When starting a business, one of the crucial decisions you’ll face is choosing the right legal structure for your company, and two popular options for entrepreneurs and small business owners are S corporations (S corps) and limited liability companies (LLCs).
This article will explore the intricacies of S corps and LLCs, highlighting their similarities and differences. By the end, you should have a better grasp of which entity type better aligns with your business goals and needs.
S Corp vs LLC: What’s the Difference?
The comparison between an LLC and an S corporation is not a strict either-or scenario. The main difference between an S corp and an LLC is that an LLC represents a distinct business structure, while an S corp is a tax filing designation. This means a business can be set up as an LLC and file taxes as an S corp.
So, let’s compare a standard LLC with one that has elected S corporation status.
What Is an LLC?
A limited liability company, or LLC, is a flexible business structure that combines the limited liability protection of a corporation with the pass-through taxation of a partnership or sole proprietorship. LLC owners are called “members.” You can form a single-member LLC (disregarded entity) or multi-member LLC.
What Is an S Corp?
An S corporation, or S corp, is a tax classification that a small business corporation can utilize to gain special tax treatment under Chapter 1, Subchapter S of the Internal Revenue Code. To qualify for S corp status, a company must meet and maintain certain criteria throughout its existence.
Similarities Between S Corps and LLCs
As S corporations and LLCs are not mutually exclusive, you’ll notice numerous similarities between them in practical terms.
Personal Liability Protection
The owners of both legal entities bear no personal liability for business debts and obligations, meaning their personal assets are protected. Instead, it is the corporation or LLC that assumes responsibility for the company’s debts and liabilities.
Important: Keep in mind that you should always consult with an attorney when looking specifically for liability protections. You should always make sure that your CPA and attorney are working together. Benefits of certain legal structures may have tax consequences you should consider, and therefore having these two professionals working together is key.
Owners of both S corps and LLCs can either be hands-off or employees of the business. They can receive compensation for their work, including a reasonable salary, bonuses, and benefits. It’s important to note that an S corporation can lose the S election if more than 25% of the activity in the S-corp is deemed to be passive activity.
Shareholders and Stock
S corps issue stock to shareholders, representing ownership interests. In contrast, LLC members hold membership interests. While these mechanisms differ, they serve similar purposes in reflecting ownership.
S corps and LLCs use pass-through taxation, meaning the business itself does not pay corporate income tax at the federal level on company profits. Instead, profits and losses “pass through” to owners’ personal income tax returns. This avoids double taxation.
Florida-based companies should note that the state of Florida does not impose state-level income tax on S corps or LLCs. However, both may be subject to state-level sales, use, and excise taxes. It is always advisable to consult with a Florida CPA firm, such as Alpine Mar, to understand all of the tax implications when you’re starting out.
Differences Between S Corps and LLCs
It is important to fully understand the differences between an S corp and an LLC.
While a typical LLC’s existence is tied to an owner’s life or departure from the business, an S corporation enjoys an independent lifespan. Its continuity isn’t contingent on shareholders, whether they choose to leave or remain, making it conducive to conducting business with a focus on long-term objectives and expansion.
S corps can have up to 100 shareholders (owners), all of whom must be U.S. citizens or residents. LLCs do not have any ownership restrictions.
Transfer of Ownership
S corp stock can be freely transferred, provided that IRS ownership restrictions are met. Transferring ownership in an LLC usually requires approval from other members in accordance with the LLC’s operating agreement.
S corps have a board of directors with officers who take care of daily business operations, while an LLC appoints member-managers to run daily operations. This might influence your business structuring decision, as forming an S corporation would likely result in reduced involvement in day-to-day business decisions.
Allocation of Profits and Losses
S corp shareholders receive profits and losses according to their ownership percentage (e.g., a 30% shareholder gets 30% of the profits and losses). In contrast, LLCs have flexibility in allocating profits and losses and can do so based on various criteria (e.g., a member with 60% ownership might be entitled to 80% of the profits and losses).
S corps can offer better self-employment tax advantages than LLCs by treating the owner as an employee, paying a reasonable salary, and withholding payroll taxes (FICA) on that amount. Corporate distributions paid beyond the salary are exempt from self-employment taxes. On the other hand, an LLC member will have to pay self-employment tax on their entire share of business income.
IRS Scrutiny Regarding Self-Employment Taxes
It’s important to note that an LLC with an S corp election is at a higher risk of IRS audits compared to one without. There have been court cases where the IRS deemed the owners’ salaries unreasonable and reclassified their non-wage distributions as wages.
Costs and Formalities
S corps generally have more administrative and compliance costs than LLCs because they must hold regular meetings, maintain corporate records, and issue stock certificates. LLCs have fewer mandatory formalities and paperwork requirements, resulting in lower administrative costs and a more straightforward operational structure.
How to Choose the Right Business Structure
Choosing between an S corp and an LLC requires careful consideration of your business goals, size, management preferences, and tax implications. Here are some steps you might consider to help you make an informed decision:
- Evaluate Your Business Goals. Consider your long-term objectives, such as growth plans, exit strategy, and the desire to attract outside investors.
- Assess Ownership and Management Preferences. Determine how many owners or shareholders you’ll have and your preferred management structure.
- Understand Tax Implications. Consult with a professional tax advisor to analyze the tax benefits and disadvantages of each type of business entity in your specific situation, including self-employment tax considerations.
- Consider Compliance and Costs. Think about the administrative and compliance requirements associated with each legal entity and how they align with your resources and preferences.
Make the Best Choice With Professional Advice
Selecting the most appropriate legal business structure is a critical decision that can significantly impact your operations and financial outcomes. While S corps and LLCs share similarities, differences in taxation, management, costs, and compliance can make one more suitable for your needs than the other.
The best way to decide between an LLC and a corporation that is taxed under Subchapter S is to consult with financial professionals who specialize in business taxation. They will provide valuable insights on each business structure that’s tailored to your unique circumstances, industry, and location.