The Main Differences Between S Corps and LLCs
*Disclaimer: we are not lawyers and are not giving legal advice. This article is simply an informational article that was researched on what the definition of each corporation is.
Whether you are starting your first business or your next business, one of the many tasks on your to-do list is to create a separate legal entity for your company. Creating a distinct entity provides a wealth of benefits, ranging from taxation benefits to limited liability if your company gets sued. Here in Spokane, WA there are many CPA’s who are qualified to help you choose the right entity type for your business.
While many entrepreneurs understand these benefits of creating a separate entity, which entity to create is an entirely separate question. Specifically, many entrepreneurs struggle to decide whether they should create an S corporation (“S Corp”) or a limited liability company (“LLC”).
In this article, we want to demystify some of the confusion surrounding these two entities. Understanding the major differences between S Corps and LLCs, you will be able to make the best possible choice for your new venture.
S Corps Explained
To start, let’s take a brief look at S Corps. S Corps are specific types of corporations that meet certain requirements that are promulgated by the Internal Revenue Service (“IRS”). The main feature of S Corps is that for federal tax purposes, S Corps pass corporate income, losses, deductions, and credits to their shareholders.
This is a big deal. S Corp shareholders can report the entity’s income and losses on their personal tax returns, allowing these shareholders to pay tax at their individual income tax rates. While this lets S corps avoid double taxation on its corporate income, S Corps must still pay taxes on passive income and built-in gains at the entity level.
There are several prerequisites for your company to be treated as an S Corp. You can find the full list of requirements here, but some of these requirements include the company (1) having no more than 100 shareholders, (2) having no more than one class of stock, and (3) being a domestic corporation.
LLCs are essentially hybrid entities. They combine certain traits of a corporation and a partnership or sole partnership. Like S Corps, LLCs offer you limited liability, meaning that creditors of your business cannot go after you personally if your LLC cannot pay its bills. Along with this, LLCs are like partnerships in that they can leverage flow-through taxation.
The owners of LLCs are called members, and members can be individuals or other types of corporate entities (like other LLCs). Unlike S Corps, there are no limits on the number of LLC members. LLC members get to elect on how the LLC should be treated for tax purposes. For instance, you and the other members can treat the LLC as a corporation, partnership, or as a so-called “disregarded entity.”
LLCs are a creation of state statutes, so you’ll want to check with your state if you are thinking of starting an LLC. For instance, many states require LLCs to document and file articles of incorporation with the state. Along with this, your state may charge certain filing fees to start your LLC. When starting your LLC, it’s critical to ensure that you are complying with all state laws during the formation process.
S Corps vs. LLCs
S Corps and LLC’s may seem pretty similar on the surface, but there are some key differences. The first goes to the heart of what S Corps and LLCs actually are. Specifically, S Corps themselves are not a particular type of business entity. S Corps are all about how your business is taxed per the IRS Code. Therefore, if you are looking for major differences between S Corps and LLCs on the operations level, you will mostly be out of luck. S Corps exist due to provisions in the IRS Code.
Beyond this basic distinction, one of the key differences between S corps and LLCs centers on self-employment taxes. All members of an LLC have to pay self-employment taxes on the LLCs profits. The current rate is 15.3% and these self-employment taxes specifically cover social security and Medicare taxes. That said, if you opt for S Corp designation for your business, the shareholder who actively works for the company is considered an employee. Why does this matter? Ultimately, only the employee’s salary is subject to self-employment taxes. If you were to distribute a dividend to yourself, for instance, that would not be subject to self-employment taxes. While the IRS will take a close look and ensure that you’re paying yourself a reasonable salary, this is a tax benefit that you may be able to leverage.
Along with this, S Corps have more restrictions than LLCs. We mentioned some of those restrictions above. If you aren’t a U.S. citizen or resident, for example, you won’t be able to create an S Corp. These formation restrictions aside, S corps run the risk of disallowing the S corp election, meaning your S Corp will be federally reclassified as a C corporation. LLCs, on the other hand, have fewer formation restrictions. They are easier to set up and provide a significant amount of freedom at formation.
Deciding What’s Best
With these distinctions in mind, you can come to a more educated and objective decision when you are forming your company. We can’t give legal advice on which entity to choose but speaking with your CPA can help you decide. A few things to keep in mind:
First is the popularity of S Corps. One study from the National Small Business Association, for example, found that 42% of businesses are structured as S corps and 23% are structured as LLCs. While you don’t necessarily need to follow the crowd, many small business owners enjoy the tax benefits of an S Corp election.
Also, keep profitability in mind. For instance, if your business has income left over after paying you a reasonable salary, an S Corp election can save you thousands in taxes. It may be hard to project your income and expenses, but by engaging in this exercise, you can come to a more objective decision.
Ultimately, by completing some due diligence and rationally thinking about the pros and cons, you can come to the best solution for your business. Consult your CPA about which entity works best for you and your business. We wish you the best of luck!