LLC vs. S Corporation: An Overview
Choosing the right business structure is crucial to the success of your business.
An LLC is a limited liability company, which is a type of legal entity that can be used when forming a business that offers protection to the owner(s) from personal liability for debts and other obligations that a business might incur. In other words, the personal assets of the owner can not be used for legal claims against the business.
LLCs are common because they provide the liability that's similar to a corporation, but they are easier to establish and with fewer regulatory requirements than other types of corporations. LLCs allow for personal liability protection, which means creditors cannot go after the owner's personal assets. An LLC also allows pass-through taxation, meaning business income or losses are recorded and taxed on the owner's personal tax return. LLCs are beneficial for sole proprietorships and partnerships. An LLC with multiple owners would be taxed as a partnership, meaning each owner would report profit and losses on their personal tax return.
An S corporation's structure also protects business owners' personal assets from any corporate liability and passes through income, usually in the form of dividends, to avoid double corporate and personal taxation. S corporations help companies establish credibility as a corporation since they have more oversight. S corps must have a board of directors who oversee the management of the company. However, S corps can have 100 shareholders and pay them dividends or cash payments from the company's profits.
An S corporation provides limited liability protection but also offers corporations with 100 shareholders or fewer to be taxed as a partnership. An S corporation is also known as an S subchapter. In some instances, a business may be both an LLC and an S corporation. (You can form an LLC and choose to be taxed as an S corporation, but your business can also operate under the default taxation system for LLCs.) A business must meet specific guidelines by the Internal Revenue Service (IRS) in order to qualify as an S corporation.
The business structure that you choose can significantly impact some important issues in your business life. These issues include exposure to liability and at what rate and manner you and your business are taxed. It can also impact your financing and your ability to grow the business, the number of shareholders the business has, and the general manner in which the business is operated.
Both LLCs and S corporations surged to the forefront around the time of the Small Business Job Protection Act of 1996, which contained a number of changes to basic corporate tax law, such as enabling S corporations to hold any percentage of stock in C corporations. C corporations, however, are not allowed to own stock in S corporations.
- An LLC is a limited liability company, which is a type of legal entity that can be used when forming a business.
- An LLC offers a more formal business structure than a sole proprietorship or partnership.
- While LLCs and S corporations are two terms that are often discussed side-by-side, they actually refer to different aspects of a business.
- An LLC is a type of business entity, while an S corporation is a tax classification.
- An S corporation election lets the Internal Revenue Service (IRS) know that your business should be taxed as a partnership.
- To become an S corporation, your business first must register as a C corporation or an LLC and meet specific guidelines set by the Internal Revenue Service (IRS) in order to qualify.
Limited Liability Company (LLC)
Limited liability companies (LLCs) are popular due to their basic benefits of liability protection and are typically used by a sole proprietor (single owner) or a company with two or more owners (partnership). LLCs protect the owners' personal assets from losses, company debts, or court rulings against the company. LLCs may also provide some tax benefits since they are taxed differently than a traditional corporation—or a C Corporation.
An LLC can be used for a company of any size, such as a doctor's or dentist's office, or as a legal entity that owns commercial property. Also, an LLC can be established by family members who conduct business in states that allow LLCs. Before establishing an LLC, entrepreneurs should consider the various characteristics that are associated with forming an LLC, which include the following.
Ownership of an LLC
An LLC is allowed to have an unlimited number of owners, commonly referred to as "members." These owners may be U.S. citizens, non-U.S. citizens, and non-U.S. residents. Also, LLCs may be owned by any other type of corporate entity, and an LLC faces substantially less regulation regarding the formation of subsidiaries.
LLC Business Operations
For LLCs, business operations are much simpler than other corporate structures, and the requirements are minimal. While LLCs are urged to follow the same guidelines as S corporations, they are not legally required to do so. Some of these guidelines include adopting bylaws and conducting annual meetings.
For example, instead of the detailed requirements for corporate bylaws for S corporations, LLCs merely adopt an LLC operating agreement, the terms of which can be extremely flexible, allowing the owners to set up the business to operate in whatever fashion they most prefer. LLCs are not required to keep and maintain records of company meetings and decisions in the way that S corporations are required to do.
Management Structure of an LLC
The owners or members of an LLC are free to choose whether the owners or designated managers run the business. If the LLC elects to have the owners occupy the company management positions, then the business would operate similarly to a partnership.
LLC Taxation and Fees
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 that 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.
LLCs avoid the double taxation, which C corporations must pay because they pass all company income through to the tax returns of the individual owners. A C-Corporation (or C-corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation. The taxing of profits from the business is at both corporate and personal levels, creating a double taxation situation.
The fees for establishing an LLC can vary by state but expect to pay nearly $500, which might include the following:
- Articles of incorporation fee, which might cost $100
- Annual reporting fees, which can cost a few hundred dollars per year
- Attorney fees if you have a lawyer draw up the legal documents
- Tax and accounting fees if you use an accounting firm to prepare financials and file taxes
How to Form an LLC
Below are several of the steps involved in forming an LLC. However, please check with your local state since they may have additional forms and requirements.
- Choose a name. The company name should follow the state guidelines in which the LLC will be formed. Also, the chosen name cannot already be an existing business name that's recorded and established.
- Assign a registered agent. Your LLC may be required to have a registered agent, which is a person or company that handles any legal papers on behalf of the LLC if there is a lawsuit. Your local office of the Secretary of State should have a listing of local companies that can act as a registered agent.
- File articles of organization with your local office of the Secretary of State. The articles of organization might also be called a certificate of formation or certificate of organization. Articles of organization are essentially legal forms that outline basic information about the company, and each state may have specific requirements. However, most states usually require the following: the name and address of the LLC, a description of the general purpose of the LLC, a list of the owners, and the name and address of the registered agent.
- Create an operating agreement. An operating agreement is an internal document that stipulates how the LLC will be run and how it will be managed. The operating agreement should include procedures for how members will be managed if there are more than one and how profits and losses will be divided between the members. The operating agreement should also outline the procedures for adding new members and when members leave. If an operating agreement is not in place and a member leaves, a state may require the LLC to be dissolved. However, the operating agreement doesn't need to be filed with your state's office. Instead, it should be kept within your business records and updated as necessary.
- Apply for a federal ID number, if necessary. If you have more than one owner, you'll need to establish an employer identification number (EIN), which is a federal ID number that identifies the company. If you're a sole proprietor, you don't necessarily need an EIN number unless you want it taxed as a corporation instead of a sole proprietorship.
- File business licenses, permits, and establish a bank account. It's important to check with your local state, county, and town offices to determine if there are business licenses and permits that need to be filed. Depending on the type of business that you'll be operating, your state may require a permit or license to be in place before you can begin operating your business. Also, if the LLC will be selling goods that are subject to a local sales tax, you'll need to file with your local tax office so that you can collect the sales taxes and remit them to the state.
It's important to note that the above list is not comprehensive since each state may have additional requirements. Once established, many states require LLCs to file an annual report, which the state may charge a fee. These fees can sometimes run in the hundreds of dollars per year.
LLC Pros and Cons
There are distinct advantages and disadvantages to establishing and operating a limited liability company.
As stated earlier, an LLC gives the owner or owners limited liability, which means that each owner is not personally liable for any company-related lawsuits or any debts that belong to the company. In other words, creditors cannot take or collect money from your personal assets to satisfy the debts of the business. Creditors are only able to take assets from the company.
LLCs are simpler to establish and operate when compared to a corporation. Corporations typically must have appointed directors, officers, and board meetings.
LLCs also have tax benefits since the company's income, or losses are reported on the owner's personal tax return. This prevents the profit generated from the business from being taxed at the business level and also taxed again at the personal level when the owner takes a salary from the company. Instead, the profit from the business passes through the business entity and is only reported once for tax purposes on the owner's personal tax return.
Another benefit of LLCs is that they are extremely flexible when it comes to their structure. There are no limits to the number of owners, called members, and LLCs can operate with only one owner, similar to a sole proprietorship. LLCs also allow the owner to designate a manager to run the business, which could be one of the designated members, a non-member, or some combination of both.
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.
An LLC can be more costly to form and operate when compared to a sole proprietorship or a partnership. As stated earlier, there can be filing fees for an EIN number and also annual fees for filing the annual report.
Personal liability protection
No double taxation
Easier to establish and operate than a corporation
More costly to establish than a sole proprietorship or partnership
Must file an annual report, and the fee can cost hundreds of dollars
Cannot attract outside investment other than banks
The choice of business entity is going to be guided largely by the nature of the business and how the owner envisions the business unfolding and growing in the future.
An S corporation's structure also protects business owners' personal assets from any corporate liability and passes through income, usually in the form of dividends, to avoid double corporate and personal taxation. Below are some of the characteristics of S corporations.
Ownership of an S Corporation
The IRS is more restrictive regarding ownership for S corporations. These businesses are not allowed to have more than 100 principal shareholders or owners. S corporations cannot be owned by individuals who are not U.S. citizens or permanent residents. Further, the S corporation cannot be owned by any other corporate entity. This limitation includes ownership by other S corporations, C corporations, LLCs, business partnerships, or sole proprietorships.
S Corporation Business Operations
There are significant legal differences in terms of formal operational requirements, with S corporations being much more rigidly structured. The numerous internal formalities required for S corporations include strict regulations on adopting corporate bylaws, conducting initial and annual shareholders meetings, keeping and retaining company meeting minutes, and extensive regulations related to issuing stock shares. Further, an S Corporation may use either accrual or cash basis accounting practices.
Management Structure of S Corporations
In contrast, S corporations are required to have a board of directors and corporate officers. The board of directors oversees the management and is in charge of major corporate decisions, while the corporate officers, such as the chief executive officer (CEO) and chief financial officer (CFO), manage the company's business operations on a day-to-day basis.
Other differences include the fact that an S corporation’s existence, once established, is usually perpetual, while this is not typically the case with an LLC, where events such as the departure of a member/owner may result in the dissolution of the LLC.
LLCs and S corporations are business structures that impact a company's exposure to liability and how the business and business owner(s) are taxed.
S Corporation Taxation and Fees
S corporations can elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The shareholders of the S corporation would report the flow-through of income and losses on their personal tax returns. As a result, the assessed tax would be calculated based on their individual income tax rates. This pass-through feature helps S corporations to avoid double taxation, meaning the company's income is taxed at the corporate level and again when dividend income paid to shareholders is taxed on their personal income tax returns.
S Corporations must use Form 1120S to file their taxes. Form 1120S is a tax document that is used to report the income, losses, and dividends of S corporation shareholders
The fees to establish an S corporation can vary significantly, depending on the complexity of the corporation and state in which it's established, but some of the fees can include:
- Fees for the articles of incorporation, which might be $100 to $250, depending on the state
- Lawyer fees to process the legal documents can range from a few hundred dollars to a few thousand dollars if the S corporation structure is more complex
- Annual reporting fees within the state might be required and can cost $500 to $800 per year
- Accounting costs for financial reporting and tax services should be considered
- Insurance costs can vary depending on the type of business
How to Form an S Corporation
- Choose a name. The company name should be chosen that is not already in use within the jurisdiction of the S corporation. Typically, the local state or town offices will have a listing of the existing corporations in the area so that you can avoid choosing a name that already exists.
- Establish and name the board of directors. A board of directors is an elected group of individuals that act as a governing body representing the shareholders. The board is required to meet at regular intervals and keep minutes for the meetings. The board is also required to establish policies for the management team. Every S corporation must have a board of directors.
- Issuance of stock for the S Corporation can be in the form of common or preferred stock.
- File articles of organization with both the IRS and the local office for Secretary of State. In addition to the articles of organization, it might be required to file a document separately stating the purpose of the business. Although the guidelines can vary by state, many states require the following information: Names and contact information of the management team and the board of directors
- Name of the S corporation
- Amount of shares issued
- How shares are allocated
- Registered agent name
- File the corporate bylaws. A document outlining the corporate bylaws is usually required to be filed with the local Secretary of State office. It typically outlines the procedures for the following:
Electing and removing directors:
- How shares of stock will be sold
- Holding meetings
- Voting rights
- How the death of a director or officer will be handled
- File Form 2553 with the IRS. Once a certificate of incorporation has been received from your local Secretary of State office showing that the S corporation has been organized, you must file form 2553 with the IRS. The form is called the Election by a Small Business Corporation, which makes the company official with the Internal Revenue Service.
- File with a registered agent. Many states require that a registered agent is to be assigned for the S corporation. The agent should receive all legal documents and correspondence between state and federal agencies.
S Corporations Pros and Cons
There are distinct advantages and disadvantages to establishing and operating an S corporation. Some of the advantages include:
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.
An established S corporation can help boost credibility with suppliers, investors, and customers since it shows a commitment to the company and to the shareholders. S corporations allow the owner to benefit from personal liability protection, which prevents personal assets from being taken by creditors to satisfy a business debt. Also, employees of an S corp are also members, which means they're eligible to receive cash payments via dividends from the company's profits. Dividends can be a great incentive for employees to work there and help the owner attract talented workers.
There are also some disadvantages to establishing and operating an S Corporation.
Although most states allow the income generated from an S corporation to be taxed on the owner's personal tax returns, some states do not. In other words, some states choose to tax an S corporation as if it was a corporation. It's important to check with your local Secretary of State office to determine how S corporations are taxed in your state.
S corporations can incur a number of fees, including those for filing an annual report, hiring a registered agent, which handles legal matters for the business, and other fees for the Articles of Incorporation filed with the local Secretary of State office.
S corporations can be more cumbersome to establish and operate than an LLC since they require a board of directors and corporate officers. Also, filing guidelines and regulations are more rigid for S corporation vs. LLCs, including for the annual shareholder meetings, issuance of stock shares, and keeping meeting minutes.
Provides personal liability protection
Doesn't pay taxes at the corporate level, allowing pass-through to a personal tax return
Can boost credibility with suppliers, creditors, and investors
Pays dividends to employees
Some states may tax S corporations as corporations; not at the personal level.
S corporations can incur more fees than an LLC.
S corporations have more regulations and guidelines that must be followed.
Owner has less control.
Which Structure Is Better for You?
For small business owners or sole proprietors, an LLC is often the easiest and most cost-effective way to incorporate. 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.
Choosing the right business structure will therefore depend on the size and scope of the company, the number of employees, the level of involvement of the owner(s), and tax considerations. While more complex business structures can allow for greater tax minimization and sophistication, they are also more expensive to create and maintain, often requiring the professional services of lawyers and accountants.
It is, of course, possible to change the structure of a business if the nature of the business changes to require it, but doing so often might involve incurring a tax penalty of one kind or another. Therefore, it is best if the business owner can determine the most appropriate business entity choice when first establishing the business.
Which Is Better, an LLC or S Corp?
An LLC is often better for a single-owner and likely better for a partnership. An LLC is more appropriate for business owners whose primary concern is business management flexibility. This owner wants to avoid all, but a minimum of corporate paperwork does not project a need for extensive outside investment and does not plan on taking her company public and selling the stock.
In general, the smaller, simpler, and more personally managed the business is, the more appropriate the LLC structure would be for the owner. If your business is larger and more complex, an S corporation structure would likely be more appropriate.
Who Pays More Taxes, an LLC or S Corp?
It depends on how the business is established for tax purposes and how much profit is going to be generated. Both an LLC and S corp can be taxed at the personal income tax level. LLCs are often taxed using personal rates, but some LLC owners choose to be taxed as a separate entity with its own federal ID number. S corporation owners must be paid a salary in which they pay Social Security and Medicare taxes. However, dividend income or some of the remaining profits (after the owner's salary has been paid) can be passed through to the owner, but not as an employee, meaning they won't pay Social Security and Medicare taxes on those funds.
Why Would You Choose an S Corporation?
An S corporation provides limited liability protection so that personal assets cannot be taken to satisfy business debts by creditors. S corporations also can help the owner save money on corporate taxes since it allows the owner to report the income that's passed through the business to the owner to be taxed at the personal income tax rate. If there will be multiple people involved in running the company, an S Corp would be better than an LLC since there would be oversight via the board of directors. Also, members can be employees, and an S corp allows the members to receive cash dividends from company profits, which can be a great employee perk.
Should I Make My LLC an S Corp?
If you're a sole proprietor, it might be best to establish an LLC since your business assets are separated from your personal assets. You can always change the structure later or create a new company that's an S corporation. An S corporation would be better for more complex companies with many people involved since there needs to be a board of directors, a maximum of 100 shareholders, and more regulatory requirements.
The Bottom Line
LLCs are easier and less expensive to set up and simpler to maintain and remain compliant with the applicable business laws since there are less stringent operational regulations and reporting requirements. Nonetheless, the S corporation format is preferable if the business is seeking substantial outside financing or if it will eventually issue common stock.
In addition to the basic legal requirements for various types of business entities that are generally codified at the federal level, there are variations between state laws regarding incorporation. Therefore, it is generally considered a good idea to consult with a corporate lawyer or accountant to make an informed decision regarding what type of business entity is best suited for your specific business.
Correction—March 10, 2022: A previous version of this article incorrectly stated that the IRS recognizes LLCs as partnerships for tax purposes, which isn't true in all cases.