When starting a business, you can choose from a variety of business entities. Two of the most common for small business owners are Limited Liability Companies (LLCs) and S-Corporations (aka S-Corp). They differ in terms of how they are set up and how they are taxed. And what many people don’t know is that an LLC can actually be taxed as an S-Corporation.
We’ll discuss more about each type of business entity below and explain some of their pros and cons to help you make a decision.
But as a heads up, if you’ve just started your business, you shouldn’t be looking at an S-Corporation, as they cost more money to set up and maintain. They only make sense once you have established revenue and profits (net income) are over $70,000 per LLC owner.
What is an S-Corp?
An S-Corporation, commonly known as an S-corp, is a tax election that informs the Internal Revenue Service (IRS) that your company should be taxed as an S-Corporation. This type of election has pass-through taxes, and therefore avoids the “double taxation” that traditional Corporations face.
In order to be taxed as an S-Corp, your company must first file as a Corporation or LLC with the state. And then you file Form 2553 with the IRS to request to be taxed as an S-Corp.
Here are some of the features of an S-corp:
- The owners of a company are referred to as Shareholders in an S-corp.
- Owners of the company become “employee-owners”, meaning they are both an owner and an employee. And for this reason, they must run payroll and take a salary.
- The earnings, losses, credits, and deductions of an S-corp are taxed at the shareholder level. This is pass-through taxation.
- An S-Corp can have 1 shareholder or up to 100 shareholders, but no more than 100 shareholders.
- Additionally, you need to be registered as an American Corporation or LLC and have the company’s operations in the United States. Non-US residents and foreign companies cannot be owners of an S-Corp.
What is an LLC?
A Limited Liability Company – or LLC – is formed by filing Articles of Organization with the Secretary of State in the state where the LLC will do business.
An LLC is a type of business entity that safeguards the personal assets of its owners, also known as “Members.” Some of the features of an LLC are:
- If the company is involved in litigation, the creditor may only pursue the assets of the company and not the individual assets of the LLC members.
- If the LLC is taxed as a Sole Proprietorship, Partnership, or S-Corporation, it will benefit from being a pass-through entity, which means that its income will “flow-through” to the LLC members’ personal tax return.
- LLCs don’t have double-taxation like a traditional Corporations.
- The LLC members are required to pay self-employment tax on their income.
- An LLC may also elect to be taxed as an S-corp, in which case the member must receive fair compensation. The LLC records this as a business cost from which it deducts payroll taxes. And dividends are paid-out from the company’s remaining earnings.
S-Corp vs. LLC – What are the Differences?
An LLC is a business entity formed at the state level. An S-Corp is a tax election made with the IRS, that “sits on top of” either an LLC or a Corporation.
So the question isn’t really “S-Corp vs LLC”, but it’s LLC taxed in default status vs LLC taxed as an S-Corp.
Note: Depending on the state where your LLC (taxed as an S-Corp) is formed, there may be additional state tax filing requirements. For example, if you open an LLC in Texas, you’ll need to check with the Texas Department of Revenue (or your accountant).
Differences in Taxes
There are several distinctions between an S-corp and an LLC taxed in its default status (Single-Member LLCs are taxed like Sole Proprietorships, and Multi-Member LLCs are taxed like Partnerships).
Each has different rules and will impact how your company taxation will be done.
- With an S-corp tax classification, a company can avoid double taxation, which occurs when a Corporation is taxed on its profits, and then again on the dividends that shareholders get as their personal income.
- State law governs LLCs, but federal tax law governs S-Corps.
- Depending on how the business owner wants their LLC to be taxed, an LLC may be taxed as an S-corp or even a C-Corp.
- Members of an LLC are obligated to pay self-employment taxes, which include Social Security and Medicare taxes, to the IRS.
- The self-employment income tax rate for Social Security and Medicare in 2020 was 12.4 percent and 2.9 percent, respectively, according to the IRS. These tax rates may fluctuate annually.
- Any revenue that an LLC earns is regarded as taxable revenue.
- In an S-corp, the shareholders get a salary and the S-corporation covers their payroll taxes, which are then deductible from the firm’s taxable income as business expenditure.
- If a company has excess earnings, they are given as dividends to the shareholders, which may be taxed at a lower rate than ordinary income, or not taxed at all.
- All LLCs do not qualify for S-Corp taxation. If your company is eligible, choosing S-Corp taxation may place restrictions on who is allowed to own the LLC and how revenues can be distributed among the owners.
- An S-Corp can only have up to 100 shareholders or owners, whereas the maximum number for an LLC (not taxed as an S-Corp) is infinite.
- Ownership of an S-Corp is restricted to individual people and certain types of Trusts.
- An LLC can be owned by a Corporation or a Partnership, for example, but an S-Corp cannot.
- Another difference between an LLC and an S-Corp is that an LLC can have non-US residents as Members, but an S-Corp cannot.
- Last but not least, S-Corps can issue stock but can only do so in one class, whereas LLCs can’t issue stock, but can instead create different membership classes. This is more complex though and not very common.
LLC or S-Corp – Which is Better for You?
A smart starting point is to file for an LLC, as this form provides liability protection and tax write-offs. However, transitioning to an S-corp may be financially advantageous when your company has enough net income to justify the extra expenses of being taxed as an S-Corporation.
Many business owners set up their new businesses as LLCs to have legal protection for their personal assets. As the LLC revenue rises, so does the self-employment tax.
However, if your company expands, you should consult a certified public accountant (CPA) and consider whether or not you should change your LLC’s default tax classification. Keep in mind that if you elect for your LLC to be taxed as an S-Corp, you’ll need to run payroll for yourself, hire a bookkeeper (this is usually much better than trying to do this yourself), file extra documents with the IRS and the state, and there are additional expenses and tax returns that are needed as well.