LLCs and S corporations (S-corps) are often talked about together, but they are not an either-or choice. A limited liability company (LLC) is a legal business structure. An S-corp is a tax classification. You can elect to have your LLC taxed as an S-corp, and many companies choose this option for tax advantages, but it’s important to know when and how these advantages apply.
Business entities and tax structures can be complicated. Understanding them can save you and your company time, money and potential headaches in the future.
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LLC and S-corp: Basic Definitions
An LLC is a legal business structure while S corporation is a tax classification that’s available to some small businesses. Both LLCs and corporations can elect S-corp taxation by filing a form with the IRS. When starting a business, it’s important to evaluate your options from both a legal and a tax perspective. Here are some factors to consider when making this decision and what’s involved in the process.
What Is an LLC?
An LLC, or limited liability company, is a legal business structure that protects the owner’s personal assets from the company’s debts. An LLC is considered a distinct entity, which means that there is a financial barrier between the company and the owner. The owners of an LLC are called members, and LLCs can be single-member or multiple-member owned.
You can think of an LLC as a hybrid between a partnership and a corporation. LLCs are a common business structure for small and medium businesses and entrepreneurs because of their simplicity and flexibility. They have more flexible management and profit-sharing options than corporations, yet they provide liability protection that’s not available to sole proprietorships or general partnerships.
“The LLC is the most recent form of entity that’s been available, and it started to get a lot more popular in the mid to late 1990s,” explained Chris Paris, a tax partner and CPA at the professional services firm Moss Adams.
Unlike partnerships and corporations, LLCs don’t have their own IRS tax category. Instead, they’re usually taxed in the same way as sole proprietorships or partnerships, depending on whether the LLC has one owner or multiple owners. However, an LLC can also elect to be taxed as an S corporation (if it qualifies) or a C corporation (C-corp).
To learn more about LLCs, including how to set one up, see our guide.
What Is an S-corp?
An S corporation is not a business entity but a tax classification. Both LLCs and corporations can be taxed as an S-corp. An S-corp doesn’t pay corporate income tax such as a traditional C-corp. does. Instead, company profits pass through to owners’ personal tax returns.
Not all businesses qualify to be taxed as S-corps. To elect S-corp status:
- You must be a U.S. business
- You cannot have more than 100 shareholders aka owners
- Shareholders can be individuals and certain trusts and estates
- Shareholders cannot be corporations, partnerships or non-resident aliens
- You can only have one class of stock.
S-corp taxation can have advantages for the owners of both corporations and LLCs. If your business is structured as a corporation, S-corp taxation allows you to avoid having company profits taxed at both the corporate and shareholder level. If your business is an LLC, S-corp taxation allows you to be a company employee, potentially saving money on taxes.
LLC vs. S-corp: Similarities and Differences
LLC and S corporation are not an either-or comparison–you can structure and operate your business as an LLC but still be taxed as an S-corp. There are several factor differences to keep in mind when you’re thinking about setting up an LLC as an S-corp.
Taxes
By default, an LLC is taxed like a sole proprietorship or partnership. the owners are considered self-employed and must report business income and expenses on their personal tax returns. Each owners’ share of the profits is subject to federal, state and self-employment (Medicare and Social Security) tax. Currently, the self-employment tax rate is 15.3%, and you’ll pay this tax on all your profits until you reach the maximum annual Social Security contribution ($142,800 in 2021)
Some LLC owners save money on self-employment taxes by electing S-corp taxation. This is because as an S-corp owner, you don’t have to be self-employed–you can become an employee of the company and pay yourself through regular payroll. Your salary will still be subject to Medicare and Social Security taxes, but any company profits over and above your salary will not.
However, the IRS scrutinizes S-corp owner salaries closely, and your salary must be reasonable, based on standard salaries in your industry, your geographic location and your experience. In other words, it must be accurate and can’t be unreasonably low to take advantage of the tax benefits.
For example, say you’re the sole owner of an LLC that made an annual profit of $100,000. And suppose a reasonable salary in your area for someone who does the same work as you is $70,000. Under the default LLC taxation, you’ll pay self-employment taxes on your full $100,000 of profit. But if your business is taxed as an S-corp, you’ll only pay payroll taxes on your reasonable salary of $70,000. The other $30,000 will still be subject to income tax, but not Medicare or Social Security taxes.
Historically, owners of S corporations have taken advantage of this tax benefit by classifying their income as zero percent salary and 100% distributions, thereby completely avoiding payroll taxes. In recent years, the IRS has become privy to this tax avoidance strategy and can impose hefty penalties. Get advice from an accountant before deciding on a tax classification for your business or determining what a “reasonable” salary should be. And be aware that setting your company up as an S-corp. may cause additional costs related to having employees and running payroll.
Management Structure
Not all LLCs qualify to be taxed as an S-corp. If your business does qualify, electing S-corp taxation could limit who can own an interest in your LLC and how profits can be apportioned among owners.
An LLC can have an unlimited number of members, while an S-corp can have up to 100 shareholders aka owners.
Only individuals and certain trusts can be owners of an S-corp, Paris explained.
On the other hand, there is a lot more flexibility regarding who can own an LLC, including a C corporation or a partnership. Additionally, an LLC does not face as much regulation as a corporation.
“LLCs are a lot more flexible in terms of how you allocate the economics and amongst the owners, whereas corporations are more rigid,” Paris said.
With an LLC, you could have various classes of equity and various degrees of participation in your equity, Paris explained, unlike an S-corp where you can only have a single class of stock.
How to Structure an LLC as an S-corp
To elect S-corp taxation, you must file Form 2553, Election by a Small Business Corporation, with the IRS. The form must be filed within 2 months and 15 days after the beginning of the tax year when the election will take effect, or at any time during the preceding tax year. See the instructions for Form 2553 for a description of how to calculate the deadline for your business and fill out the form.
When Should Your Company Become an S-corp?
An LLC owner might want to become an S-corp for the tax advantages while avoiding dealing with the state law formalities of corporations, which would require having officers, directors, board meetings and board minutes.
It could be a good time to consider becoming an S-corp when the company generates enough profit to make the change in tax structure worth it.
Disadvantages of an S-corp
Because an S-corp will mean more complicated tax withholdings, you can expect your accounting fees to increase, especially if you wouldn’t otherwise have employees and payroll expenses. An S-corp may also require separate tax filings. Therefore, it may only be worth operating an LLC as an S-corp when your company reaches a certain income threshold, and the additional costs and fees make sense from an accounting perspective.
If you’re on the fence about whether or not it makes sense to structure an LLC as an S-corp, it’s a good idea to speak to an accountant about the specific additional costs and the income threshold that justify the tax benefits of an S-corp. If you are just getting started with your business and are still unsure about how much income your LLC will generate, you may want to consider holding off on setting it up as an S-corp.
Frequently Asked Questions
Are S-corp earnings subject to self-employment tax?
Owners of an S-corp may be considered employees and, if so, must be paid a reasonable salary. If you own an LLC that is structured as an S-corp, for example, you will pay yourself a reasonable salary. That salary will be subject to Medicare and Social Security taxes (which are referred to as employee payroll taxes rather than self-employment taxes), but the rest of the company’s profit will not be. This is different from an LLC that is taxed as a partnership or disregarded entity, where all of the company’s profit is considered income and thus subject to self-employment tax.
Can you switch from an LLC to an S-corp?
You may opt to have your LLC taxed as an S corporation by filing Form 2553 to be treated as an S corporation.
Do I really need an LLC?
An LLC can be useful in saving your company a great deal of money and protect it from all sorts of legal pitfalls in the future. Check out our guide to the best LLC services to help make the process of filing an LLC less stressful.
How do you form an LLC?
You form an LLC by filing paperwork with your state. It’s relatively easy to do online or with the help of an attorney. We explained the step-by-step process in our guide to setting up an LLC.
How can I be sure my business is eligible for S-corp status?
The IRS offers all the fine print on eligibility in its Instructions for Form 2553. Before making any moves, business owners should seek out all relevant details about eligibility requirements and see how these stack up with the specifics of their businesses.
How many different kinds of LLCs are there?
There are eight different kinds of LLCs that you can form. These include a single-member LLC for a one-person company; a multimember LLC, which can be either manager-managed or member-managed; a foreign LLC, which is set up outside of the country in which you reside (known as a domestic LLC); a series LLC (SLLC), which provides oversight to several smaller LLCs (only allowed in 18 states, Washington, D.C. and Puerto Rico); a low-profit LLC (L3C), which is a hybrid of a nonprofit organization and a for-profit corporation; an anonymous LLC, which allows the owner or owners to operate in the manner of a silent partner; a restricted LLC, which is a specific type of LLC that deal with the transferal of family assets like real property; and a professional LLC (PLLC), which is designed for companies whose members usually have to have regulatory board licenses like attorneys and doctors. Note that a PLLC is not allowed in California. A limited liability partnership (LLP) or professional corporation must be created instead.
