Each has pros and cons, but this article focuses on two of the most popular options for small businesses: S corporations and LLCs.
S corporation vs. LLC: An overview
When choosing between an S corporation and LLC, there’s no one “best” choice for all small business owners. Here’s a quick overview of each. We’ll dive into each of the difference in more details later.
|Definition||Also known as a “Subchapter S corporation” or “small business corporation.” A special tax status granted by the IRS that combines the legal protection of a corporation with the taxation of a partnership or sole proprietorship.||A corporate structure allowed under some state statutes. Easier to set up than corporations but provide a more formal structure and liability protection from creditors than sole proprietorships or partnerships.|
|# of owners||Maximum of 100||Unlimited|
|Share of profits||Only one class of stock allowed. Each outstanding share receives equal rights to profits.||The operating agreement can specify whether profits are shared equally or there are different units of membership.|
|Who can own||Must be U.S. citizen or permanent resident. Another business entity cannot be a shareholder.||No restrictions on ownership|
|Operations||Must adopt bylaws, hold annual meetings, and keep meeting minutes.||Flexible and governed by the operating agreement.|
|Length of existence||Perpetual. If one owner dies, their shares may be transferred to another owner or heir.||Limited. When a member dies, the LLC is usually dissolved.|
|Tax filing||Form 1120S||Depending on the number of members and elections made, may file Schedule C, Form 1065, Form 1120S, or Form 1120.|
|Owner salaries||Owners are considered employees of the business and receive a salary with income and payroll taxes withheld.||Owners take distributions of profits. The business doesn’t withhold income or self-employment taxes from distributions.|
Differences between S corporations and LLCs
Both LLCs and S corporations are “passthrough” entities. This means the business doesn’t pay federal income taxes on its profits. Instead, income and deductions “pass through” to the owners, who pay taxes for business profits on their personal tax returns.
But that’s where the similarities end. There are several ways in which LLCs and S corporations differ.
S corporations and LLCs have different rules when it comes to who can own them.
Owners of an LLC are commonly referred to as “members.” An LLC can have an unlimited number of members. Those members don’t have to be citizens or residents of the U.S. Members of an LLC can even be other businesses, such as S corporations or C corporations.
Owners of an S corporation are known as shareholders. The IRS is much more restrictive when it comes to shareholders of an S corporation. An S corporation cannot have more than 100 shareholders. Those shareholders must be U.S. citizens or permanent residents. An S corp can’t be owned by another business entity.
There aren’t many legal requirements for operating an LLC. In most states, new businesses simply need to register with the state and adopt an operating agreement.
Members have a lot of flexibility in how they structure the operating agreement. They can give all members equal ownership or different units of ownership. The operating agreement can appoint one member to manage the LLC, or several managers who are appointed by the members.
Rules for operating an S corporation are much more rigid. An S corporation has to adopt corporate bylaws, hold annual meetings, and keep minutes from those meetings. They’re also required to have a board of directors and corporate officers. If the S corporation has only one shareholder, that owner may take on several roles.
Transfer of ownership
Transferring ownership is one of the few areas where LLCs have less flexibility than S corporations. LLC owners can usually only transfer ownership with the approval of the other members. Shareholders of an S corporation can freely transfer their stock.
If an LLC member passes away, that’s normally the end of the LLC. On the other hand, an S corporation continues after a shareholder passes away. Their ownership in the company may revert to another shareholder or an heir.
LLCs and S corporations are both pass-through entities that allow the business to pass income and deductions through to the owners to pay taxes on their personal income tax returns. However, LLCs have a few options for they file tax returns..
Single-member LLCs file tax returns like sole proprietors. Instead of filing a separate tax return for the business, the owner reports business income and losses on Schedule C attached to the owner’s Form 1040 individual tax return.
Multi-member LLCs typically file the same tax return used by partnerships, Form 1065. Then the LLC gives each member a Schedule K-1 showing their share of the business’ income, deductions, and credits.
Both single-member LLCs and multi-member LLCs can elect to be taxed as either a C corporation or an S corporation by filing Form 8832 with the IRS. At that point, the company files a tax return using either Form 1120S or Form 1120.
LLC members are self-employed. They don’t receive a paycheck from the business or have income or payroll taxes withheld from their paychecks. Instead, members make estimated quarterly payments towards their income and self-employment taxes.
S corporation owners are considered employees of the business. They receive a reasonable salary and have income and payroll taxes withheld from their paychecks. If the owner takes additional money out of the business, it’s considered a distribution. Those distributions decrease the owner’s share of equity.
Should I make my LLC an S corp?
Because of the difference in the way LLC and S corporation owners are paid, some LLC members save money by electing to have their business treated as an S corporation. This is because S corp owners pay Social Security and Medicare taxes only on their salary, while LLC members pay self-employment taxes (the self-employed version of FICA) on 100% of their share of the LLC’s profits.
However, before making an S corp election, it’s important to compare the tax benefits to the full cost of running structuring your business as an S corp.
Additional costs of making an S corporation election:
- There may be additional fees due to the state for converting the LLC to an S corp
- The LLC may need to get a new operating agreement and draft new by-laws
- Your tax situation will be more complicated, and you may have to pay more to file your tax returns
- You must set up payroll and tax withholding for the S corp owners’ salary. In most cases, this involves hiring a payroll service.
To get a full picture of whether making an S corp election will save you money, talk to a tax professional.
Whichever business entity you choose, you always have the option of changing it down the road. You may want to start your business as an LLC for the legal protection but make an S corp election later on if it will result in tax savings.
If you’ve done your research and still don’t know which business structure to choose, talk to your lawyer or accountant. They can review your goals and expected income and help you decide which type of entity is right for you.