Starting a business can be a fascinating experience. After years of nursing that fantastic idea, you're finally ready to turn your dreams of owning a company into reality and become your own boss. But before you can start making sales and raking in profits, you first need to decide on an entity type or a legal structure for your business.
Should you go for an S corp or a limited liability company (LLC)? Benzinga explores the similarities and differences between an S corp and an LLC to help you decide which entity type best fits your current and long-term business goals. Let's dive in.
What is an S Corp?
An S or subchapter corporation is a tax classification that can help protect small business owners or entrepreneurs from double taxation. The implication is that an S corp is not strictly a business entity type but a classification based solely on tax. You can also imagine an S corp as a "lite" version of a C corp. LLCs and general corporations (or C corps) can elect to be taxed as S corps. Unlike traditional C corps, S corps are not subject to taxes on the corporate level; instead, the company's profits and losses pass through to the owner's personal or individual tax returns — the so-called pass-through taxation.
C-corps are taxed at the corporate level on profit from the business and the personal income level after distribution or when shareholders receive dividends, known as double taxation. A company must meet specific compliance requirements after incorporation to elect the S-corp status. These include capping shareholders (or members, in the case of an LLC) at 100 persons (excluding corporations, partnerships or non-resident aliens), having one class of stock and other compliance requirements as stipulated in the IRS regulations.
S-corp allows owners to be employees. As an owner-employee, you must pay yourself a reasonable salary or compensation for your work. The salary is subject to federal and state income tax and Social Security and Medicare taxes. However, additional profits received as distributions are not subject to these taxes, enabling you to save.
What is an LLC?
An LLC is a legal business designation that offers entrepreneurs and business owners personal liability protections from business obligations. This implies that the owner's assets (real estate properties, cash or its equivalent, personal savings, jewelry, cars and collectibles) are protected from company debt, losses, bankruptcy or court rulings against the company. The owners of an LLC are called members. Members can range from one person (single-member LLC) to several individuals (multiple-member LLC). There's no limit. LLCs are hybrid entities with characteristics of a general corporation (or C corps) and general partnerships.
Like a C corps, an LLC grants members personal liability protection. Like a general partnership or sole proprietorship, an LLC uses pass-through taxation. An LLC can elect to be taxed as a C or S corp (if it qualifies) by filing IRS Form 2553. An LLC is one of the most popular business entities and the favorite among budding entrepreneurs looking to incorporate their company and business owners looking to enhance their business credibility and take it to the next level. The reason is that besides personal assets protection and tax benefits, an LLC offers the most simplified and flexible approach to company formation, management and organizational structure. In addition, it provides excellent profit-sharing options.
Similarities Between an S Corp and an LLC
S corps and LLCs share a lot of similarities.
Limited Liability Protection
S corps and LLCs provide owner's personal liability protection, the cornerstone of business registration or incorporation. Liability protection implies that the owner's personal assets are protected if the business gets sued, incurs debts or becomes bankrupt or fails. Remember that personal assets differ from business assets, and liability protection doesn't extend to the business asset, which is better covered by insurance.
Pass-Through Taxation
S corps and LLCs are essentially pass-through entities, meaning that the business pays zero taxes at the corporate level. Instead, the business profits and losses are passed through to the individual owners and reported on their personal tax returns. LLCs can also elect to be taxed as a C corp or S corp if it benefits the company.
Separate Legal Entities
S corps and LLCs are separate or independent entities, meaning that they're financially and legally distinct from the owners and have rights slightly similar to individuals. For instance, both can enter into contracts, hire employees, loan out or borrow money, own assets, sue or get sued and do much more in their name.
Compliance Requirements
As legal entities created by state filings, LLCs and S corps must maintain specific compliance requirements in the state where they operate to avoid penalties or involuntary dissolution. The requirements vary among states but generally involve annual report filing, maintaining a registered agent and notifying the Secretary of State regarding any changes in the business operations, name, entity type or management.
Flexible Ownership Structures
S corps and LLCs have flexible ownership structures, meaning one person or several individuals can own them. Remember, though, that S corp ownership is capped at 100 individuals.
Differences Between an S Corp and an LLC
Despite their similarities, S corps and LLCs significantly differ in various ways.
Ownership Restrictions
An S corp has stiffer or more restrictive ownership requirements stipulated by the IRS. For instance, the number of shareholders must be at most 100 individuals who must be U.S. citizens or permanent residents. Corporations, partnerships, LLCs and various trust companies cannot be owners. An S corp can only issue one class of stocks — common or preferred. In contrast, LLCs have no ownership restrictions or membership limits. Members may include foreigners and foreign entities, including corporations, partnerships and trusts. LLCs can have subsidiaries.
Management Structure
LLCs can be controlled and managed by their members (member-managed) or an appointed manager (manager-managed). There's often no distinction between the manager and members of an LLC, especially in member-managed LLCs. In contrast, an S corp has a more rigid structure, comprising a board of directors that oversees corporate affairs and decision-making and corporate officers that handle day-to-day operations. Ownership transfer
Except clearly stated in the operating agreement, membership stake or ownership in an LLC is not freely transferable. It often requires the approval of other members. In contrast, shareholders can easily and freely transfer their shares or ownership stake in an S corp, guaranteed it doesn't violate the IRS regulations.
Formalities
S corps has more mandatory compliance requirements, which means more extensive internal formalities than LLCs. For instance, S corps must hold initial and annual director and shareholder meetings, maintain detailed records of corporate actions, adopt bylaws, issue shares of its stocks and follow other corporate formalities. LLCs have lesser formalities and record-keeping requirements.
For instance, while having an operating agreement is vital, most states do not mandate LLCs to have one. LLCs are also not required to hold annual member's meetings or to document evidence of such meetings. Nevertheless, LLCs must file annual reports, maintain registered agents and pay fees as required.
Profit Allocation or Distribution
Distributions or allocation of profits and losses in S corps are purely based on percentage ownership or stake in the business. For instance, if you hold a 20% ownership stake or company shares, you're entitled to 20% profit or losses. In contrast, LLCs have no defined basis for profit and loss allocation. A member with 20% shares or ownership interest might be entitled to 50% profit or losses.
Self-Employment Taxation
LLC owners are considered self-employed, so in addition to the federal and state income taxes, the business profits are also subject to self-employment (Medicare and Social Security) taxes. The current rate is 15.3%, which you must pay until you reach the stipulated maximum annual Social Security contribution of $147,000 as of 2022. In contrast, as an S corp, you can become a company employee and pay yourself via regular payrolls.
In this case, while your salary will still be subject to self-employment tax, any profit over and above your pay is untaxed. Therefore, an S corp may offer a lifeline to LLC owners looking to save on self-employment tax. Remember that your salary must be reasonably within what is obtainable in your profession and geographical location. If your business is merely breaking even, the hassles of electing to be taxed as an S corp may not be worth it. Either way, a CPA can provide better guidance and direction.
Transform Your Small Business and Take the First Step Towards Growth by Incorporating as an LLC or S Corp
Whether you're enthusiastic about starting an LLC or launching an S corp, you must ensure the core benefits influencing your decision will positively impact your business in the long and short term. There's no need for a sudden rush when making a choice. Take time to constructively understand each entity, especially its tax structure and other core benefits that may fit your business needs.
Are you planning to scale up soon? Has your business reached a consistent growth level? Are you looking for minimum upkeep and enhanced operational simplicity and flexibility, all while enjoying limited personal protection? Would self-employment tax positively affect your net worth? Are your business partners U.S. citizens? Answering these questions will help you take your business to the next level of growth and profitability.
Frequently Asked Questions
Why choose an S corp over an LLC?
You can choose an S corp if you hope to save on employment tax or you want to leverage some of the core advantages of a corporation, like raising capital via share or IPO issuance and scaling up your business.
Should all small businesses incorporate?
While incorporating your business enhances its credibility, it’s not mandatory that you incorporate it. Nevertheless, should you choose to incorporate, consider the long and short-term benefits and disadvantages and how that relates to your business needs.
Is an S corp better for small businesses?
While an S corp has excellent benefits, the best choice depends on individual business needs and goals.