S corporation vs. LLC: An overview
When choosing between an S corporation and LLC, there’s no one “best” choice for all small business owners. Both entity types offer personal liability protection to their owners, meaning personal assets are protected in the case of bad debt or legal action.
Both filing types are also enticing since they offer similar benefits to incorporating while avoiding double taxation. Corporations effectively pay taxes twice, on both a corporate income tax return and on the shareholders’ individual tax returns. S corporations and LLCs only pay taxes once: on the shareholders’ individual tax returns.
But choosing between the two will depend on the needs and goals of the business.
Here’s a quick overview of each. We’ll dive into each of the differences in more detail later.
How Bench can help
Opting to be treated as an LLC or S corporation can create big benefits for your business. But there’s one change every business can make to save the time and stress of staying on top of financial reporting: outsourcing your bookkeeping.
With Bench, you have a dedicated team of bookkeepers tracking every business expense and recording every sale. We give you a full picture of the financial health of your business year round allowing you to scale and grow. If you have a fear of filing, we can even take care of your taxes. Learn more.
Differences between S corporations and LLCs
Both LLCs and S corporations are “pass-through” entities. The business doesn’t pay federal income taxes on its profits. Instead, income and deductions “pass through” to the owners, who pay taxes on any business profits on their personal tax returns.
But that’s where the similarities end. There are several ways in which LLCs and S corporations differ.
Regardless of whether you’ve chosen to become an LLC or S corporation, you’ll need to file documents with your state to have your business be considered a separate entity.
An LLC is responsible for filing articles of organization with their chosen state. Your articles of organization outline the rights, duties, powers, and obligations of each member of the LLC. If you’re unsure what to include, start with a free template, or check out our guide on forming an LLC for more information.
There are multiple paths to getting S corporation designation. You can start as an LLC and then file Form 2553 with the IRS. Alternatively, you can file articles of incorporation with the Secretary of State for your business to become a legal entity under state law and then file Form 2553 to opt for S corporation status. Check out our guide on S corporations for complete steps. Either way, you’ll need to file Form 2553 and must meet the strict requirements to become an S corporation.
It’s also important to open up a separate business bank account. After going through the process of setting up a business with personal liability protection, the next logical step is to make sure your personal assets and funds are completely separated from the business.
Suggested reading: Top 7 Noteworthy Banks for Your Small Business
S corporations and LLCs have different rules when it comes to who can own them.
Owners of an LLC are commonly referred to as “members.” An LLC can have an unlimited number of members. Those members don’t have to be citizens or residents of the U.S. Members of an LLC can even be other businesses, such as S corps or C corps.
Owners of a business filing as an S corporation are known as shareholders. The IRS is much more restrictive when it comes to shareholders of an S corporation. An S corporation cannot have more than 100 shareholders, and those shareholders must be U.S. citizens or permanent residents. Unlike LLCs, an S corp can’t be owned by another business entity.
There aren’t many legal requirements for operating an LLC. In most states, new businesses simply need to register with the state and adopt an operating agreement.
Members have a lot of flexibility in how they structure the operating agreement. They can give all members equal ownership or different units of ownership. The operating agreement can set one member to manage the LLC or several managers who are appointed by the members.
Rules for operating an S corporation are much more rigid. An S corporation has to adopt corporate bylaws, hold annual meetings, and keep minutes from those meetings. They’re also required to have a board of directors and corporate officers. If the S corporation has only one shareholder, that owner may take on several roles.
Transfer of ownership
Transferring ownership is one of the few areas where LLCs have less flexibility than S corporations. LLC owners can usually only transfer ownership with the approval of the other members. Shareholders of an S corporation can freely transfer their stock, while LLCs can’t even issue stocks to investors.
If an LLC member passes away, that’s normally the end of the LLC. On the other hand, an S corporation continues after a shareholder passes away. Their ownership in the company may revert to another shareholder or an heir.
LLCs and S corporations are both examples of pass-through entities. Pass-through entities pass income and deductions through to the owners to pay taxes on their personal income tax returns rather than paying a federal corporate tax. This means business owners pay taxes based on their individual tax rates.
However, LLCs have a few options for when they file their tax returns.
- Single-member LLCs file tax returns like sole proprietors. Instead of filing a separate tax return for the business, the owner reports business income and losses on Schedule C attached to the owner’s Form 1040 individual tax return.
- Multi-member LLCs typically file the same tax return used by partnerships, Form 1065. Then the LLC gives each member a Schedule K-1 showing their share of the business’ income, deductions, and credits.
Both single-member LLCs and multi-member LLCs can elect to be treated as either a C corporation or an S corporation for tax purposes if they file Form 8832 or Form 2553 with the IRS. At that point, the company files a tax return using one of two federal tax forms: Form 1120S to file as an S corporation or Form 1120 to file as a C corporation.
LLC members are self-employed. They don’t receive a paycheck from the business or have income or payroll taxes withheld from their paychecks. Instead, members make estimated quarterly payments towards their income and self-employment taxes.
S corporation owners are considered employees of the business. They receive a reasonable salary and have income and payroll taxes withheld from their paychecks. If the owner takes additional money from the business, it’s considered a distribution. Those distributions decrease the owner’s share of equity.
Should I make my LLC an S corp?
Because of the difference in how LLC and S corporation owners are paid, some LLC members save money by electing to have their business treated as an S corporation. This is because S corp owners pay Social Security and Medicare taxes only on their salary, while LLC members pay self-employment taxes (the self-employed version of FICA) on 100% of their share of the LLC’s profits.
However, before making an S corp election, it’s important to compare the tax benefits to the full cost of structuring your business as an S corp.
Additional costs of making an S corporation election:
- There may be additional fees due to the state for converting the LLC to an S corp
- The LLC may need to get a new operating agreement and draft new bylaws
- Your tax situation will be more complicated, and you may have to pay more to file your tax returns
- You must set up payroll and tax withholding for the S corp owners’ a reasonable salary (even if you’re an early-stage startup). In most cases, this involves hiring a payroll service.
If you’re considering making an S corp election, talk to a tax professional to see if it makes sense for your business.
Whichever business entity you choose, you always have the option of changing it down the road. You may want to start your business as an LLC for the legal protection it offers but make an S corp election later on if it will result in tax savings.
If you’ve done your research and still don’t know which business structure to choose, talk to your lawyer or accountant. They can review your goals and expected income and help you decide which type of entity is right for you.