Are you unsure about what type of business entity to set up for your company?
You may be considering an LLC or S corp. As a business owner, what you choose to set up as your company's legal structure can have an impact on what taxes you'll pay and what liability protection you will enjoy.
This article will cover the differences between these two entities and help you decide which one is right for your business.
We'll explore what each type of entity can do and what it cannot do before comparing them in detail.
What are LLCs?
An LLC is a limited liability company. When you set up a limited liability company, it gives your company protection from personal liability.
That means that the LLC owners or operators of the LLC cannot lose their assets outside of what's in the LLC if there are creditor claims against them personally, for example.
Small business owners usually choose a limited liability company (LLC) because it's the most flexible of all small business structures.
Sometimes one LLC is set up for a group, while other times, they can be established individually.
An LLC does not need to have any specific number or type of shareholders, and there are no restrictions on what percentage share each person owns in the company.
This means that an individual with one share and one person with 99 shares could both be owners of the company.
How are LLCs Taxed?
Limited liability companies pay taxes solely on what is known as "pass-through" income. Pass-through means that LLC members are only taxed on the money they receive from their company, not what it makes or what debt it takes on.
Passing this responsibility to LLC owners separates them from any liability incurred by the business and offers what is known as "limited liability protection."
Multiple owners of an LLC will have to figure out how much personal income tax they owe by proportionately determining their percentage ownership in the business.
If there are multiple shareholders with different percentages, then personal income tax is determined through Schedule E (Form 1040) filed with the Internal Revenue Service along with their personal tax return.
What Is the Business Structure of an LLC?
An LLC is a business entity that combines some personal aspects with an estate and corporation.
The personal aspect of this type of business structure limits the liability for personal assets while also giving the owner control over decisions in how their company is operated.
The formal business structure of an LLC protects against personal liability, but the owner cannot access certain personal tax benefits.
Limited liability companies offer flexibility in business management is structured so the company can be member-managed or manager-managed.
The number of LLC owners (members) is unlimited, and the managerial role can be performed by another member or someone outside the company altogether.
The advantages of an LLC include personal assets protection, self-employment tax advantages, and personal income tax benefits.
The personal asset protections of an LLC allow the business owner to shield personal property from liability when they are sued by third parties, for example.
Another benefit is the ability to shield personnel from self-employment tax.
Small businesses which choose to be LLCs also enjoy personal income tax benefits.
The LLC as a separate entity means earnings are not subject to self-employment taxes, and the owner's personal assets are shielded from liability in case of a sue by third parties.
LLCs are not the perfect solution for everyone.
Some of the LLC disadvantages to consider are the costs and transferable ownership.
Setting up an LLC can be costly and time-consuming. This is true for all business entities, primarily because of the personal liability protections that make LLCs challenging to buy and sell.
Transferable ownership can also be a disadvantage, which means that the person who originally founded the company cannot transfer their percentage in order to cash out without finding someone willing to take on some personal risk.
What are S Corporations?
S Corps are a small, personal business that is taxed as a corporation. One or more people can own them, and their personal assets do not need to be used for the company's debt.
Corp owners are personally responsible for the company's debt, and personal assets are not used to pay off any of these business debts.
S Corps are similar to LLCs because they offer limited liability protection. Still, partners in an S corp can be held individually liable for taxes on earnings from their personal investments if they have equity in those investments.
S corps can avoid double taxation because personal income includes personal salaries.
Income is also susceptible to self-employment taxes (Social Security/Medicare taxes).
How Are S Corporations Taxed?
An S Corp is taxed as a personal company. It does not pay taxes as a separate entity, and the owner's personal assets are off-limits to creditors.
S corps are not subject to double taxation like C corporations. An S corp does not pay double taxation like a C corporation because it pays personal income tax and then pays corporate taxes.
Unless it's passive income or capital gains, S corps are exempt from personal self-employment taxes.
If you are an owner of the S corp, then your personal income is not subject to self-employed tax because it's all taxed at personal levels.
Your spouse will have to pay self-employment tax on his/her personal salary, however, if they work for the company as well.
The exception is if you are the one receiving personal benefits from your S corp like a car or housing, then self-employed taxes will be assessed on these personal benefits.
S Corp owners also receive a reasonable salary, which is included in their personal income.
A reasonable salary is calculated according to the IRS's guidelines for personal benefit.
To determine a reasonable salary, you will need to consider your employees' experience and training, their responsibilities, duties, dividend history, and so on.
What Is the Business Structure of an S Corp?
The simplest S Corp is managed by its shareholders.
Typically, the shareholders elect a board of directors and hire officers to act as corporate officers.
Officers are charged with managing the company and overseeing day-to-day affairs.
They are assigned jobs like legal, accounting, or business operations management positions (to name a few).
An S corp is not allowed to have over 100 shareholders, and they have to be citizens of the US.
S Corp advantages
An S Corporation is a business entity that provides pass-through taxation, meaning the profits and losses of the company are passed through to be taxed on each owner's personal income.
It may come in handy for liability reasons but is better suited for smaller companies - investors have some security through stocks.
Still, a larger company would find it difficult to pass their assets between owners without incurring double taxation by generating more costs than they can pay for themselves.
Apart from the pass-through taxation, an S corp offers limited liability protection to the business owners.
It also provides flexibility so that an S corp can elect to be taxed as a C corporation reasonably easily.
The owners only have to file the C corp election with the Internal Revenue Service.
Lastly, an S corporation can continue to exist perpetually, so its existence can never expire.
S Corp Disadvantages
One of the disadvantages of an S corporation is that it has to comply with stringent federal tax law.
An S corp must also allocate profits and losses according to shares or ownership percentage.
All business profits and losses are allocated to the members based on how many shares they own so that these amounts can be included with individual income tax filings.
What Are the Main Differences Between an LLC and an S Corporation?
The main difference between LLCs and S Corps is that an S corporation is not a business entity per se, unlike an LLC.
An S Corporation is a tax classification that signals the IRS to tax it as a partnership.
You will either have to register your business as an LLC or a C Corp before becoming an S corp. However, certain circumstances allow a business to be both an LLC and an S Corporation.
Unlike LLCs (especially single-member LLC), S corporations have to be run by a board of directors who oversee the management.
What Are the Benefits of an LLC vs. An S Corp?
An LLC has "pass-through" taxation, where profits from the company go directly onto its owners' personal tax returns.
This means that you only have to pay a personal income tax rate applied to the company's profits, not a personal and business income tax rate.
An LLC also has some protection from personal liability because it's considered a separate entity in court cases.
Small businesses can benefit from an LLC more than from an S Corp. To be precise, an LLC limits your liability and personal exposure as a business owner, offers unique legal benefits, such as pass-through taxation at the individual level.
On the other hand, larger business structures are more likely to benefit from an S Corporation.
Larger S corporations also face the challenge of dividend income and remaining profits that should be passed through to owners but remain untaxed.
Related Article: LLC Electing To Be Taxed As an S Corp
Which Is Better for Taxes LLC or S Corp?
When it comes to tax savings, there is no clear-cut winner.
Some tax experts believe that LLCs are better for taxes, while others argue it's the other way around.
This comes down to personal and company preferences about personal assets versus business liability protection.
However, self-employment tax is why many business owners choose corporation taxation.
LLCs are taxed differently than corporations. The owners of S Corporations can be regarded as its employees and be paid a reasonable salary, which the government will take FICA taxes out of.
The corporate earnings that remain after the owner's salary can be treated as unearned income and can not be subject to self-employment tax.
Am I Considered Self-Employed if I Own an S Corp?
The owners of an S corporation pay income tax on their earnings, but they do not have to pay self-employment taxes because they can't be regarded as employees.
If the owner is also an employee and will receive a salary, then Social Security and Medicare taxes are withheld for that individual too.
Can One Person Be an S Corporation?
Yes, one person can be an S corporation.
For tax purposes, S corps are a separate business entity from its owner.
Strictly speaking, any single-member LLC that has chosen to be taxed as an S corporation is a one-member S corporation.
Can You Have an S Corp With No Employees?
Technically, you can have an S corp with no employees. However, it has to make payments to the board of directors and officers, and those have tax implications, meaning they are potentially treated as employees with taxable income.
Can a Single-Member LLC Be an S Corp?
Yes, an LLC with only one owner (single-member) can be an S corp.
As a single-member LLC owner, you are not considered self-employed, so no federal self-employment tax is required.
However, it is common to be taxed on company profits as a salary when you are an LLC.
This means you can then take the remaining profit as a dividend and avoid employment-related taxes with few personal income tax implications.
To avoid self-employment taxes, you can elect S Corp tax status while operating as a single-member LLC with disregarded entity status (similar to a sole proprietorship).
How Do I Make My LLC an S Corp?
To make an LLC an S corp, you must first file Form 2553 (Tax Election by a Small Business Corporation) with the Internal Revenue Service.
You will need to check whether your business meets S-Corp qualifying requirements before filing the form with the IRS.
Some requirements stipulate that your business must be a domestic company with no more than 100 members.
There are additional requirements too, si it's best to check them in detail with the Secretary of State.
LLCs and S corps are two business entities that have received much attention.
Some may believe LLCs provide the best tax advantages, while others argue for personal asset protection in a corporation.
However, to make this decision, an individual needs to consider personal assets and self-employment taxes when forming their own LLC or S corp.