LLC vs S Corp – What are the Differences, Advantages & Taxes?
When starting a business, one of the biggest decisions you will need to make is deciding your business structure.
By law, you have to decide which legal formation you want for your business.
Many new business owners decide to form as either a LLC (limited liability company) or a S Corporation (S Corp), but what is the difference and how do you know which is a better fit for your company?
Today we are going to learn all about LLC’s and S Corporations and dive into the pros, cons, advantages, and more!
Let’s get started so that you can decide which business entity you will need to form!
LLC vs S Corp – What are the Differences, Advantages & Taxes?
LLC (Limited Liability Company)
An LLC is a popular and safe option for most small business owners.
It provides a flexible business structure and is fairly simple to set up.
Why business owners choose an LLC:
- Business owners are not liable for the company’s debts and can choose their own management structure.
- They qualify for pass-through taxation – meaning that profits are only taxed once.
Each business structure has its own advantages and features but for the majority of small businesses, an LLC is going to be the best choice.
LLC’s are simple, flexible and protect your personal assets.
An LLC (limited liability corporation) is a business structure designed to protect business owners from being personally liable for the company’s debts or other liabilities.
Furthermore, LLC’s can be owned by more than one person known as LLC “members”.
If the business doesn’t do as well as planned or you have a rough year, you as the business owner are personally protected under an LLC.
For example, if your LLC declares bankruptcy or is sued, your personal assets such as your vehicle, personal bank accounts, and house are safe.
Single-member LLC’s are pass-through entities which means that profits and losses from the LLC are “passed through” to you and taxed as personal income.
This benefits you because you are not required to pay both corporate and personal taxes on your earnings.
Multi-member LLC’s are taxed as partnerships and are also pass-through entities.
This means each owner pays personal income taxes on their portion of the profit.
Benefits of an LLC
- No member limit- The owners or members of an LLC are free to choose whether the owners or designated managers run the business and how many member they want.
- Personal asset protection – as mentioned above, your personal assets are protected should your LLC go bankrupt or be sued.
- Pass-through taxation benefits – Limited liability companies are taxed differently from other corporations. An LLC allows pass-through taxation, which is when the business income or losses pass through the business and are instead recorded on the owner’s personal tax return. As a result, the profits are taxed at the owner’s personal tax rate. A single-member LLC is typically taxed as a sole proprietorship. Any profits, losses, or deductions, which are business expenses that reduce taxable-income, are all reported on the owner’s personal tax return. An LLC with multiple owners would be taxed as a partnership, meaning each owner would report profit and losses on their personal tax return.
- Simple to set up and maintain – no annual meetings, formal officers, or complicated records.
- Flexible – LLC’s have very little restrictions regarding the company’s structure. You decide if you want your business to be a single member LLC, multi-member LLC, and so on.
- LLC’s are a widely recognized business structure and bring credibility to your organization.
- Access to financing – Once your LLC is formed, you can start to build a credit history which opens the door to business loans and financing to grow your business.
- Flexible profit sharing – LLC’s can choose how they want to do their profit sharing, they are not required to be equally distributed among members.
Cons of an LLC
- Somewhat expensive formation and maintenance – More costly to establish than a sole proprietorship or partnership and LLC’s must file an annual report, and the fee can cost hundreds of dollars
- Potential Funding challenges – One of the disadvantages of an LLC is when ownership needs an injection of cash or money. If the LLC had gotten turned down for a bank loan, it could be difficult for the owner to attract money from outside investors. A corporation might be able to raise cash from venture capitalist firms, which provide money to businesses in exchange for a share of the profits. Venture capitalists usually only fund corporations and not privately-owned LLCs.
- Limited Liability can have limits – In a court proceeding, a judge can rule that your LLC structure doesn’t protect your personal assets. The action is called “piercing the corporate veil,” and you can be at risk for it if, for example, you don’t clearly separate business transactions from personal, or if you’ve been shown to have run the business fraudulently in ways that resulted in losses for others.
- Self-Employment Tax – By default, the IRS considers LLCs the same as partnerships for tax purposes, unless members opt to be taxed as a corporation. If your LLC is taxed as a partnership, the government considers members who work for the business to be self-employed. This means those members are personally responsible for paying Social Security and Medicare taxes, which are collectively known as self-employment tax and based on the business’s total net earnings.
- Member turnover – In many states, if a member leaves the company, goes bankrupt or dies, the LLC must be dissolved and the remaining members are responsible for all remaining legal and financial obligations necessary to terminate the business. These members can still do business, of course; they’ll just have to start a whole new LLC from scratch.
LLC Key Takeaways
- For LLC’s, business operations are much simpler, and the requirements are minimal.
- An LLC is a type of business entity that’s owned by its members. The entity is separate from the members.
- Simple to set up and maintain – no annual meetings, formal officers, or complicated records.
- Limited liability companies are taxed differently from other corporations. An LLC allows pass-through taxation, which is when the business income or losses pass through the business and are instead recorded on the owner’s personal tax return. An LLC with multiple owners would be taxed as a partnership, meaning each owner would report profit and losses on their personal tax return.
- Easy to setup and maintain and cheaper than other business types
- LLC’s have very little restrictions regarding the company’s structure. You decide if you
- want your business to be a single member LLC, multi-member LLC, and so on.
S Corporations (S Corp)
An S Corp is similar and different to an LLC in a few key ways.
According to the Internal Revenue Service “S Corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.”
Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates rather than at a corporate tax rate.
However, there are certain qualifications that need to be met in order to be approved for an S corporation status:
- Must be a domestic corporation
- Allowable shareholders – individuals, certain trusts, and estates and may not be partnerships, corporations, or non-resident alien shareholders.
- Cannot have more than 100 shareholders and only one class of stock
- Certain business types such as financial institutions, insurance companies, and domestic international sales corporations are not eligible for an S corporation election.
Benefits of an S Corp
- Liability protection – Much like an LLC, an S corporation provides liability protection for the personal assets of its shareholders. So long as there isn’t a personal guarantee, a shareholder does not have personal liability for the business debts and liabilities of the corporation.
- Pass-through taxation – An S corporation does not pay federal taxes at the corporate level. Any business income or loss is “passed through” to shareholders who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns to reduce income tax paid.
- Tax-favorable characterization of income – Shareholders of an S corporation can draw “reasonable” salaries as employees of the business. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation.
- Easy transfer of ownership – Interests in an S corporation can be freely transferred without triggering adverse tax consequences. The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.
- Easier accounting – Unlike Corporations, an S Corporation can use the cash method of accounting unless they have inventory.
Cons of an S Corp
- Expensive Formation and maintenance – S corporations are required to first incorporate the business by filing Articles of Incorporation with the desired state of incorporation, obtain a registered agent for the company, and pay the appropriate fees. Many states also require ongoing fees and annual reporting requirements as well as franchise tax fees.
- Reporting errors and tax errors – In rare cases, mistakes regarding the various election, consent, notification, stock ownership and filing requirements can accidentally result in the termination of S corporation status.
- Stock restrictions – S corporations can only have one class of stock and no more than 100 shareholders. Also, foreign ownership is prohibited completely.
- Increased IRS scrutiny – Because amounts distributed to a shareholder can be dividends or salary, the IRS scrutinizes payments to make sure the characterization conforms to reality. As a result, wages may be re-characterized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be re-characterized as wages, which subjects the corporation to employment tax liability.
- Less flexibility in allocating income and loss – Because of the one-class-of-stock restriction, an S corporation cannot easily allocate losses or income to specific shareholders. Allocation of income and loss is governed by stock ownership, unlike a partnership or LLC where the allocation can be set in the operating agreement. Also, the necessary accumulated adjustment account can be cumbersome to maintain, requiring input from an accounting professional.
- Taxable fringe benefits – Most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2 percent of the corporation.
S Corp Key Takeaways
- S-corporations, like partnerships, are pass-through entities.That is, there is no federal income tax imposed at the corporate level. Instead, an S-corporation’s profit is allocated to its shareholder(s) and taxed at the shareholder level (personally).
- S-corporation annual tax returns are filed using the Form 1120s
- Shareholders must receive a “reasonable” amount of compensation before they are exempt from paying self-employment tax on their share of an S-corp’s profits.
- S-corporation taxation is similar to partnership taxation in that owners are taxed upon their share of the business’s income, regardless of whether or not it is actually distributed to them.
- Distributions from the business are not taxable so long as they are not in excess of the shareholder’s basis in the S-corporation.
- An S corporation usually does not pay federal taxes at the corporate level. As a result, an S corporation can help the owner save money on corporate taxes. The S corporation allows the owner to report the taxes on their personal tax return, similar to an LLC or sole proprietorship.
- S corporations have more regulations and guidelines that must be followed
- The IRS is more restrictive regarding ownership for S corporations than for LLCs.
- Subject to higher IRS scrutiny.
- Expensive formation and annual fees
S Corporation in LLC
To take advantage of the structural benefits of an LLC combined with the taxation benefits of an S Corp, you can establish your business entity as an LLC and then make the election to have it treated as an S corporation by the IRS for income tax purposes.
The main reason to prefer S corporation tax treatment over partnership treatment has to do with employment taxes.
Under the Code, an owner of a business taxed as a partnership-who is employed by the business-is considered an owner.
An owner of an entity taxed as an S corporation who works for the business is considered an employee.
With an entity taxed as an S corporation, only the wages paid to its owner/employees are earned income subject to FICA tax for Social Security and Medicare.
Other net earnings that pass-through to the owners are considered dividend income.
This means those payments are not subject to SECA tax-provided the owner materially participates in the business-and they are not considered passive income.
Thus, an LLC taxed as an S corporation can do some tax planning that cannot be accomplished in an LLC taxed as a partnership or disregarded as an entity.
How is a S Corporation in LLC Taxed?
S-corporations, like partnerships, are pass-through entities.
That is, there is no federal income tax imposed at the corporate level.
Instead, an S-corporation’s profit is allocated to its shareholder(s) and taxed at the shareholder level (personally).
S Corporations may be liable for Income Tax, Estimated Tax, Employment Taxes, and Excise Tax.
If you are an S corporation shareholder, then you may be personally liable for Income Tax and Estimated Tax.
The biggest tax benefit of an S corporation is that shareholders do not have to pay self-employment tax on their share of the business’s profits.
Each owner takes a “reasonable” salary that is subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation.
As a result, the savings from paying no self-employment tax on the profits only kick in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”
Jeff is the sole owner of his S-corporation, a marketing agency.
His revenues from the business are $70,000 per year, and his annual expenses (not counting salary) equal $20,000.
This makes his S-corporations profit for the year be $50,000 ($70,000 – $20,000 = $50,000).
Jeff pays himself a salary of $40,000, and counts the remaining $10,000 as profit, thus saving money as a result of not having to pay self-employment tax on the $10,000 profit.
Denise forms an S-corporation and contributes $40,000 cash to the business.
In the calendar year in which the business is formed, the business pays Denise a salary of $30,000, after which it has remaining ordinary business income of $20,000.
During the year, the corporation also makes a distribution to Denise of $25,000.
When Denise forms the corporation, her cost basis in the business is $40,000 (the amount she contributed).
The $20,000 ordinary business income increases her basis to $60,000, and the $25,000 distribution reduces her basis to $35,000.
$35,000 is her cost basis at the end of the first year.
The $30,000 salary will be taxable to Denise as ordinary income, and it will be subject to normal payroll taxes as well.
The $20,000 ordinary business income will be taxable to Denise as ordinary income, but it will not be subject to payroll taxes or self-employment tax.
The $25,000 distribution will not be taxable to Denise at all, because her cost basis before the distribution was greater than $25,000.
A business owner who wants to have the maximum amount of personal asset protection plans on seeking substantial investment from outsiders or envisions eventually becoming a publicly-traded company and selling common stock will likely be best served by forming a C corporation and then making the S corporation tax election.
It is important to understand that the S corporation designation is merely a tax choice made to have your business taxed according to Subchapter S of Chapter 1 of the Internal Revenue Service Code.
An S corporation might begin as some other business entity, such as a sole proprietorship or an LLC.
The business then elects to become an S corporation for tax purposes.
Most new business owners elect an LLC as their business formation type because it is simple to form and easy to maintain.
However, as mentioned above, there are some circumstances where an S Corp makes more sense in terms of tax purposes.
If you know that a LLC is the right option for your business, checkout our step-by-step guide to setting up your LLC.
If you know that a S Corporation is the option for your business, checkout our S Corp guide here.
For those that are still on the fence, we highly recommend speaking to a tax professional to determine which formation type is appropriate for your business.
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