Choosing the Best Option for You (2024)

Choosing the Best Option for You (2024)


There’s one question every new entrepreneur needs to answer as they start a business: How will that business be structured?

The answer is a choice of two common types of business structure: An LLC or an S corp. Limited liability companies (LLCs) let you protect your personal assets from lawsuits. S corps also protect your assets, but help you avoid double taxation. The two entities can be paired together for tax purposes, though there are restrictions. 

Ahead, you’ll learn the differences between these two entities and how to choose the best structure for your business.

What is a limited liability company (LLC)?

An LLC is a business structure that sets up a company as its own entity, giving you liability protection. This means that the owner(s) of the business can’t be held financially liable for debts or lawsuits against them. 

Imagine you and a friend decide to start an ecommerce business selling jewelry. You’re excited about the idea, but worried about the risks. If something goes wrong, you don’t want to lose your personal savings or belongings. That’s where starting an LLC comes into play. 

“LLCs are commonly used for small to mid-sized businesses,” says Justyna Mueller, partner at James Moore Certified Public Accountants and Consultants. “What’s interesting about LLCs is that they have no tax code. You have to choose who you want to be taxed.

“An LLC can be taxed as a C corporation, which has a flat 21% federal corporate tax rate and enjoys additional tax deductions. Or, LLCs can be taxed as a pass-through business entity, like an S corporation. A pass-through entity files a tax return, but pays no tax itself. The income it makes is recorded on the owners’ individual tax return.” 

Justyna also explains that LLCs are easier to manage than C corporations because there are fewer state-imposed requirements for running the business. C corps need to have board meetings and record minutes, which is often a requirement that’s waived for LLCs. 

Benefits of an LCC

  • Owners are not personally liable for the company’s debts or liabilities. Their personal assets, such as houses or cars, are protected.
  • Owners can choose to be taxed as a sole proprietorship, partnership, C corporation, or S corporation, allowing them to select the most favorable tax treatment.
  • LLCs generally are easier to establish and maintain compared to other types of corporations, with fewer formalities and eligibility requirements.
  • LLCs can be member-managed or manager-managed. If you’re a new startup with hands-on owners, you might prefer a member-managed setup. 

Drawbacks of an LLC

  • You might be subject to self-employment taxes, which can be higher than the taxes paid by shareholders of an S corporation.
  • LLCs cannot issue stock, which may limit their ability to attract investors and grow the business.
  • Establishing an LLC in a state that you do not live in (known as a “foreign” LLC) can incur annual fees, requiring you to find a registered agent in that state. 

What is an S corp?

S corporation, or S corp, is short for “Subchapter S corporation.” It’s a tax classification in the US Internal Revenue Service’s Internal Revenue Code chapter that legally permits certain corporations to pass corporate income and losses through to shareholders.

As noted, S corporations are pass-through entities, which means taxes are paid only at the shareholder level. Justyna explains that this is a big benefit of forming an S corp, because it “allows S corporations to avoid the double taxation that plagues traditional C corporations. Shareholders also need not pay self-employment taxes on their share of profits, provided they receive reasonable compensation.” 

To start an S corp, you have to qualify by filing Form 2553, Election by a Small Business Corporation, with the IRS. In addition, your business must also meet the following requirements:

  • S corporations are limited to a maximum of 100 shareholders.
  • They must be a domestic corporation, organized under the laws of a state or territory of the US.
  • Only certain people, trusts, and estates can be owners. No partnerships, corporations, or non-resident alien shareholders. 
  • Owners are not eligible to participate in cafeteria plans.
  • An S corporation can have only one class of stock. 

Benefits of an S corporation

  • S corp shareholders are not personally liable for the company’s debts and liabilities.
  • S corps are not subject to corporate income tax. Instead, income, deductions, and credits pass through to shareholders, who report this information on their personal tax returns.
  • Shareholders can be treated as employees, potentially reducing self-employment taxes compared to LLC members.

Drawbacks of an S corporation

  • S corps are limited to 100 shareholders, who must be US citizens or residents.
  • S corps cannot be owned by other corporations or partnerships.
  • S corporations must follow more formalities compared to LLCs, such as holding regular shareholder and board meetings, maintaining minutes, and adhering to additional record-keeping requirements.
  • S corps are required to allocate profits and losses to shareholders in proportion to their ownership interest.

Key differences between LLC and S corps

LLCs and S corporations have several differences in formation, administration, and taxation processes. LLCs that elect to be taxed as an S corp must follow S corp processes.

LLC S corp
Formation Files articles of organization and operating agreement. Files articles of incorporation and creates corporate bylaws. Must file with the IRS and register for local/state license.
Payroll No salary required. Must pay W2 salary to working owners.
Taxation You choose tax status. Salary taxed, distributions lower taxes.
Management No member limit, flexible ownership. 100 shareholder limit, board required.
Operations Simple setup, minimal paperwork. Complex, requires annual meetings.

Formation

  • LLC: Requires creating an operating agreement and filing articles of organization. You can choose your tax status and must register for a state/local business license.
  • S corp: Requires filing articles of incorporation and creating corporate bylaws. You must file IRS Form 2553 (S corp election) and register for a state/local business license. 

There are two separate processes for forming an LLC versus an S corp. The following steps are required to start a business as an LLC:

  • File articles of organization with your state.
  • Create an operating agreement that outlines the ownership structure of the LLC.
  • Choose a registered agent who is responsible for receiving any communication to the LLC.
  • Register for a state and/or local business license.

The final step of creating an LLC is to choose the company’s tax status when you apply for an employer identification number (EIN) with the IRS. To choose the S corp status, you must file Form 2553, which confirms your eligibility based on the number of shareholders—there must be at least one and no more than 100.

Additionally, the business must follow operating protocols to maintain S corp status. The business must hold regularly scheduled meetings of directors and shareholders. Minutes of those meetings must be recorded per the company bylaws.

The state in which you incorporate may also charge an annual filing fee for S corps. Check on your state’s business site to determine whether or not you must file and pay a fee each year.

Payroll

  • LLC: No salary required. All income is treated as pass-through entity income.
  • S corp: Must pay W2 salary to working owners. Profits beyond salary are treated as distributions. 

Owners of S corps—if they actively work for the company—must be compensated with a reasonable salary, paid via payroll. Company profits beyond that salary income may be taken as distributions. LLC owners are not required to be compensated via salary; rather, they can take all business income as pass-through income.

Taxation

Compare:

  • LLC: Partnership tax, pass-through income tax, self-employment tax.
  • S corp: Salary subject to payroll and income taxes. Distributions taxed as ordinary income. 

There are major differences in taxation when comparing an LLC to an S corp. An LLC with no special tax election is taxed either as a sole proprietorship or a partnership, depending on the number of owners. 

Either way, the business’s profits are passed through to the owner(s). Instead of paying corporate taxes, the owner pays income tax as well as self-employment tax, which covers Social Security and Medicare contributions. The self-employment tax rate is 15.3%.

Choosing to be taxed as an S corp can help to reduce the amount of self-employment tax you must pay. That’s because the owner’s salary is subject to payroll taxes and income taxes, but all company profits beyond that can be taken as distributions, which are taxed as ordinary income. Self-employment taxes do not apply to distributions.

📚Learn: How To File Business Taxes for LLC: What To Know

Management structure

  • LLC: No limit on number of members, flexible ownership structure, no board of directors required.
  • S corp: Maximum of 100 members, must have a board of directors. 

Another difference between operating as an LLC and an S corp is how ownership can be structured. There’s no limit to how many members or owners of an LLC there are. But once you choose an S corp election, the LLC may have no more than 100 members.

This may not be an issue for solopreneurs or small business owners, but should be kept in mind if you intend to scale the business or need outside investment. S corp owners must also share the same type of stock; shares can’t be split between common and preferred. 

Finally, an S corp must have a board of directors and officers. Solopreneurs can simply fill this role themselves, but the process does add a level of complexity when there are multiple owners.

Operations

  • LLC: Simple set up, articles of organization, operating agreement.
  • S corp: Complex set up, corporate bylaws, annual shareholder and board of directors meeting. 

It’s simple to start an LLC; you need articles of organization and an operating agreement to file within the state law. But you’ll need some additional documents in order to operate as an S corp as well, including:

  • Corporate bylaws
  • Minutes from annual shareholder meetings
  • Minutes from annual board of directors meeting

It can be helpful to get external assistance if you’re unsure of the proper procedures for recordkeeping. A tax adviser with experience in small business is a great starting point for determining all of the correct steps to take with your state and the IRS.

Similarities between LLCs and S corps

LLCs and corporations also have their similarities: 

  • Liability protection: With both entities, the business owners’ personal assets are protected from debts and legal liabilities. 
  • Pass-through taxation: Both types of corporations get pass-through taxation by default. LLCs are only taxed differently if specified. 
  • Formation and maintenance requirements: While specific requirements differ state by state, both S corps and LLCs must file articles with the state, pay a filing fee, and comply with state-specific requirements. 
  • Easy ownership transfer: S corps and LLCs can both transfer ownership, but the process is a little different. S corps have restrictions on the number and types of shareholders, but LLCs must get approval from other members, as per their operating agreement. 
  • Life of the entity: Both structures allow for perpetual existence, which means the entities live on regardless of whether you quit, retire, or pass away. 

LLC vs. S corp: Choosing the best option for you

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An S corporation may be best for you if:

  • You’ll benefit from pass-through taxation, avoiding double taxation
  • You have 100 or fewer shareholders
  • Your shareholders are US citizens, resident aliens, or certain trusts and estates
  • You desire limited liability protection for shareholders
  • You want flexibility in allocating personal income and losses
  • You aim to save on self-employment taxes for shareholders
  • You only need one class of stock
  • You prefer a simpler corporate structure with fewer regulations
  • You plan to distribute profits according to ownership shares
  • You may want to easily convert to a C corp in the future

An LLC may be best for you if: 

  • You want to protect your personal assets from potential business debts or lawsuits
  • You prefer the option to choose between being taxed as a sole proprietorship, partnership, or corporation, depending on your business needs
  • You want a business structure with fewer formalities and paperwork compared to a corporation
  • You prefer pass-through taxation, where business profits and losses are reported on your personal tax return
  • You want the freedom to have any number of owners (members) in your business, including individuals, corporations, or other LLCs
  • You seek flexibility in allocating profits and losses among members, rather than a fixed distribution based on ownership percentages
  • You prefer the option to choose between member-managed or manager-managed structures
  • You want to enhance your business’s credibility by having a formal business structure that shows potential clients, investors, and partners that you are serious about your venture
  • You are comfortable with the regulations and requirements specific to the state where you plan to form the LLC, including fees, annual reports, and taxes
  • You believe your business has the potential for growth, and an LLC structure can provide a solid foundation for scaling and potentially attracting investors

Make smart tax choices as a business owner

For some LLCs, there may be tax benefits to enjoy by choosing to be taxed as an S corp. There are multiple legal steps that need to be taken in order to stay in compliance with both federal and state regulations. But the extra effort may well be worth it if you can lower your overall tax liability as an entrepreneur.

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LLC vs. S corp FAQ

Which is better: S corp or LLC?

Choosing between an S corp and an LLC depends on the specific needs and circumstances of the business owner. An S corp is generally more tax efficient, while an LLC provides greater flexibility in management and profit distribution.

Why choose an S corp over an LLC?

An S corp may be chosen over an LLC due to potential tax savings, as it allows income, deductions, and credits to flow through to shareholders and be taxed at individual rates, avoiding double taxation. Additionally, S corps can help reduce self-employment taxes for owners.

Is an S corp better than a single-member LLC?

Whether an S corp is better than a single-member LLC depends on the owner’s goals and requirements. An S corp can offer tax advantages and lower self-employment taxes, but a single-member LLC may be easier to manage and offer greater flexibility in profit distribution.

Can an LLC become an S corp?

Yes, an LLC can elect to be treated as an S corporation for tax purposes by filing Form 2553 with the IRS. The LLC gets to benefit from the tax structure of an S corporation while still having the operational flexibility and limited liability protection of an LLC.

How do state rules vary for LLCs and S corps?

Depending on the state, LLCs and S corps may have different formation requirements, compliance obligations, taxation, and governance requirements. They may also have different tax advantages or simplified administrative procedures in some states. Consult your state-specific guidelines when choosing between an LLC and an S corporation.

What are the tax benefits of an S corp vs LLC?

One of the main tax benefits of an S corp is self-employment tax savings. S corp shareholders can work for the company and receive salaries, which incur payroll taxes. All profits of an LLC, on the other hand, are subject to self-employment taxes if they are taxed as sole proprietorships or partnerships.



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