S Corp vs LLC: A breakdown of differences and benefits
S Corp vs LLC — not sure which one you should go with? In this article, we'll explain the advantages and disadvantages of each for your next business.
If you are planning to start your own business, or are in the process of coming up with a plan, one of the first decisions you need to make is how to structure the business. Each business type has personal asset protection, operational implications, management structure, and tax laws. LLCs and S corporations are known for being some of the more popular options. In some cases, a business may even be both of these business types.
With that said, here’s what you need to know about these business types and the difference between them before making a final decision on which one suits your business needs.
What is a Limited Liability Company (LLC)?
A Limited Liability Company (LLC) is a type of business structure that protects the personal assets of the owner. If the company ends up in legal trouble or sued by debt collectors, the creditor or plaintiff can only go after the business assets, not the personal assets of the LLC owner.
When the LLC is taxed as a sole proprietorship, it gains a tax advantage of being known as a pass-through entity, meaning its profits “pass through” the business to the LLC members, so they can report the profits on their personal tax returns instead of filing a corporate tax return. The members of the LLC need to pay self-employment tax on their income.
On the other hand, an LLC could potentially be taxed as an S corporation or even a C corp, which means the member needs to be paid a reasonable salary. It is then reported by the LLC as a business expense and deducts payroll taxes. The company’s remaining profits are distributed as dividends.
What is an S Corporation?
An S corporation, otherwise known as an S-corp or S subchapter, is considered a tax election that enables the IRS to acknowledge a business needs to be taxed as a partnership. S corp also prevents the company from incurring corporate-level double taxation. To make your company an S corporation, it must be registered as a C corporation or LLC.
In the case of an S corporation, the business owners are known as shareholders. The owners are considered an employee of the company and need to pay themselves a reasonable salary. An S-corp’s credits, deductions, profits, and losses are all taxed at the shareholder level.
If you want your business to qualify for an S-corp, it needs to have one to 100 shareholders. If you are an U.S. Citizen, the company must be located in the U.S. and the business owner needs to file with the IRS as an American corporation.
Differences between LLCs and S Corps
At times, small business owners choose limited liability company over an S corporation because of the amount of freedom it offers. However, before deciding on either of these options, it’s essential to know the differences between the two.
Business operations of an LLC
When it comes to an LLC, business operations are far more manageable than other corporate structures. Its requirements are easier to meet as well. While LLCs are prompted to follow similar guidelines as S-corps, it’s not legally required to do so. Several guidelines you can expect include conducting annual meetings and adopting bylaws.
LLC management structure
The members of an LLC have the freedom to decide on whether the owners or designated managers run the company. If the LLC votes to have the owners occupy the business management positions, then the company needs to operate just like a partnership.
LLC fees and taxation
LLCs are taxed differently compared to other corporations. The LLC enables pass-through taxation. That is when an organization’s income or losses pass through the business and are instead recorded on the business owner’s tax return. That results in the profits being taxed at the business owner’s tax rate. For single-member LLC, it is usually taxed as an owner-employee.
Any deduction, profits, or losses that are considered business expenses and lower taxable income is reported on the business owner’s personal tax return. Any LLC that has multi-member LLC is taxed under a partnership, meaning each owner needs to report profit and losses on their personal tax returns. Furthermore, LLCs can avoid double taxation to which C corporations are known to pay because they pass every company income through a tax return of the business owners.
Establishing an LLC will vary from state to state, but you will be expected to pay a fee of $500, which could include some of the following:
Annual reporting fees, which may cost hundreds of dollars per year
Articles of incorporation fee
Attorney fees when drawing up legal documents
Tax and accounting fees
Business operations for an S-corp
There is a noteworthy legal difference when it comes to formal operational requirements since S corporations are known for being more strictly structured. The many internal formalities necessary for S-corps include firm regulations on accepting corporate bylaws, overseeing initial and annual shareholder meetings, keeping and preserving business meeting hours, and extensive regulations when it comes to issues related to stock shares. Moreover, an S corporation is permitted to use either accrual or cash basis accounting methods.
S-corp management structure
For an S corporation to operate, it needs to have a board of directions and corporate offices. The board of directors is in charge of controlling the management team along with overseeing some of the more significant corporate decisions. Corporate offices, such as chief executive officers (CEO) and chief technology officers (CTO), are the ones who manage the company’s daily business operations.
Other notable differences include the fact that once an S corporation has been established, it is generally long-lasting. That is not a common case when it involves LLC, where events such as the departure of one of the founders can result in the disbanding of the LLC.
S-corp fees and taxation
S corporations can pass corporate income, deductions, credits, and losses through their shareholders for federal tax purposes. Businesses that use the S-corp structure can claim the corporate income, dedication, credits, and losses through their shareholders for federal tax purposes. The shareholders would need to report the flow-through of income and losses on their personal tax returns. Consequently, the assessed tax is then calculated based on their individual income tax rates. That pass-through feature assists S-corp to steer clear from double taxation, meaning the organization’s income is taxed at the corporate level and again when dividend income paid to shareholders is taxed on their personal income tax returns.
To establish an S corporation, the fee you pay can differ depending on the complexity of the corporation and the state it is based on. There are several fees you can expect to pay, such as:
Annual reporting fees
Fees on the articles of incorporation
Instead of being required to pay self-employment taxes and income tax on every distribution from the company, an S corp owner pays only FICA and income taxes on their salary and only income taxes for distributions. That could lead to tax savings in the best circumstances.
How to form an LLC and S Corporation
If you are a new business interested in forming either LLC or S Corporation, there are several steps you need to take. Additionally, make sure you check with your local state since it may have some additional forms or requirements you need to sign.
Forming a Limited Liability Company
1. Choose a name
The first step is to choose a name for your company. The name you decide on needs to follow the state guidelines in which the LLC is being formed. Moreover, the name you choose should not be the same as an existing company that is documented.
2. Appoint a registered agent
There is a possibility that your LLC may need to appoint a registered agent. The appointed agent can be a person or company that manages any legal papers on behalf of the LLC if a lawsuit is filed. The local office of the Secretary of State tends to have a listing of local companies that are skilled enough to act as registered agents.
3. Articles of organization
The next step is to file the articles of organization with the local office of the Secretary of State. The articles of organization may have a different name in your state, such as a certification of organization or certificate of formation. Articles of organizations are legal documents that outline the basic information about the business. Each state may have some particular requirements that you need to meet, so check them carefully. However, most states generally require the following items: Name and address of the LLC, a description of the purpose of the LLC, a list of owners, and the name and address of the registered agent.
4. LLC operating agreement
Operating agreements are an internal document that specifies how the LLC will be managed and how it will operate. The operating agreement needs to include the procedures for how members shall be managed if there is more than one and how profits and losses are divided between the members.
The document needs to outline the procedures for including new members and when members leave the organization. If an operating agreement is not established and a member leaves the organization, a state may require the LLC to be dissolved. However, the operating agreement does not need to be filed with the state’s office. Instead, you can keep it within your business records and update it when necessary.
5. Federal ID number
It may be necessary for you to apply for a federal ID number. If there is more than one owner, it is essential to establish an employer identification number (EIN), which is a Federal Id number that identifies the business. If you’re a sole proprietor, then you may not need an EIN unless you want it taxed as a corporation instead of a sole proprietorship.
6. Licenses and bank accounts
It’s crucial that you check in with your local state, country, and city offices to determine if there are any business licenses or permits you need to obtain. Depending on the business you are trying to run, your state may require either a license or permit in place before your business operations can start. Plus, if the LLC is selling products that are subject to local state tax, you need to file with your local tax office so you can collect the sales tax and remit them to the state.
When you start to set up your LLC, keep in mind that everything we mentioned above is not a comprehensive list. The state you live in may have additional requirements that will require you to look deeper into. When you have established yours, plenty of states require LLCs to file an annual report, which may have a fee charge. The fees may even at times cost hundreds of dollars per year.
Forming an S Corporation
Now, let’s go over what you need to do to qualify for an S Corporation status.
1. Choosing a name
The first step requires you to choose a name for your company. Similar to the LLC, you need to choose a name that is not already in use within the jurisdiction of the S corporation. Generally, the local state or city office has a list of existing corporations in the area that can help you avoid picking a name that is already in use.
2. Set up and name the board of directors
For this part, you need to establish and name the board of directors. They are an elected group of people that act as the governing body representing the shareholders. One of the requirements of a board is to meet at frequent intervals and keep minutes for the meetings. The board is also responsible for establishing policies for the management team. Marketing also helps with promoting your business. It is mandatory for an S-corp to have a board of directors. Issuance of stock for the S-corp can be in the form of common or preferred stock.
3. Articles of organization
Articles of organization need to be filed with the IRS and the local office of the Secretary of State. It may also be necessary to file another document confirming the overall purpose of the company. However, guidelines do vary by state, with many of them requiring some of the following information: Names and contact information of the board of directors and management team, name of the S corporation, how shares are allocated, registered agent name, and amount of shares issued.
4. File corporate bylaws
Next, you need to file for the corporate bylaws. This is a document that outlines the corporate bylaws and needs to be filed with the local Secretary of State office. It generally outlines the procedures for some of the following :
Voting and removing directors
How the death of a board member or officer is managed
5. File Form 2553 with the IRS
When you have finally received the certificate of incorporation from your local Secretary of State office showing that the S corporation has been established., you need to file form 2554 with the IRS. The form also goes under the name of Election by a Small Business Corporation, which ensures the company becomes an official business entity with the IRS.
6. Appoint a registered agent
Plenty of states require you to appoint a registered agent for your S Corporation. The agent needs to receive every legal document and correspondence between state and federal agencies.
Which one is better, LLC or S Corp?
It depends on the type of business you are attempting to run. Filling an LLC is a decent way to get started because the structure grants you liability protection and tax write-offs. However, as the company expands beyond the startup stage, changing over to an S corporation could make better financial sense. Since income from an LLC rises, so does the self-employment tax.
LLC causes the income to pass through the owner, who needs to pay a higher percentage of self-employment tax. If the business owner lives abroad, the Foreign Earned Income Exclusion can minimize the income tax, but not self-employment taxes. IN the case of an S-corp, the business owner can take a salary from the profits and apply the Foreign Earned Income Exclusion to lower the income tax.
S corporations make more sense from a financial standpoint for plenty of businesses. But unless there is a specific reason to switch over, it may not be the best strategy for a single-member LLC. It all comes down to which of them suits the needs of your current predicament.
Is it better to be taxed as an S Corp or LLC?
The answer depends on how the company is established for tax purposes and how many business profits are created. Both LLC and S corps have a taxable income at the personal level. LLCs are taxed through personal rates, but some LLC owners choose to be taxed as a separate entity with a personal federal ID number. S corp owners need to be paid a salary in which they pay Social securities and Medicare taxes. Even so, dividend income or some of the remaining profits (once the S corp owner’s salary is paid) is permitted to pass through to the owner, but not as an employee. That means they are not required to pay Social Security and Medicare taxes on those funds.
LLC and S-corps both have their uses when it comes to operating a business. LLC is excellent for people who are launching their startup companies, while S-corps fit for more established companies that have grown more complex over the years. Applying for either of them will take time and research on your end. However, if you register your LLC or S-corps with doola, you will have all of your applications swiftly filed away at an affordable price.
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