Choosing the proper business structure for your company is an important decision. Many entrepreneurs' two most popular options are a Limited Liability Company (LLC) and an S Corporation (S Corp).
While both structures offer legal protection from personal liability and provide tax advantages, there are several key differences between the two.
What Is An LLC?
Forming an LLC allows owners—or members—to receive protection from personal liability for the company's financial obligations. However, it is essential to note that an LLC does not pay taxes; the corporation distributes profits and losses among its members, who must report these amounts on their tax filings.
You can read about what an LLC is in more detail here.What Is An S Corp?
An S Corp is a particular type of corporation that elects to pass corporate income, deductions, and credits through the shareholders for federal tax purposes. This process means the corporation does not pay taxes on its earnings; profits or losses are reported on each shareholder's tax return.
An S Corp also provides limited liability protection to its shareholders, similar to an LLC.
Difference Between LLC And S Corp
Here are the differences to consider.
Membership Limit
The first significant difference between an LLC and S Corp is that an unlimited number of members can be part of an LLC, whereas S corps have a maximum limit on the amount shareholders that they may have.
The limit for S Corps is currently set at 100 individual members in the United States. So if you plan on having more than 100 shareholders in your company, then an LLC may be your better option.
Non-U.S Citizens/Residents
Another difference between these two types of entities is that non-U.S citizens/residents cannot become shareholders in an S corporation but may join as members for LLPs (limited liability partnerships). This process implies that if you want to bring non-U.S citizens or residents into your business as investors or partners, you would need to choose an LLC instead of an S corp.
Subsidiaries Ownership
Subsidiaries can freely exist under LLC's ownership versus having restrictions regarding owning them within an S Corp.
If you plan on starting multiple companies within the same entity or acquiring other companies under yours, then the best option would be to form an LLC instead of an S corp since this will make things much simpler from a legal perspective.
For instance, if you wanted to start a holding company with several subsidiaries under it, then forming an LLC would be much easier than creating multiple separate corporations for each subsidiary business.
Paperwork Formalities
While formalities like stock issuance are necessary for S Corps., membership shares will suffice from LLccs-- making life much easier from a paperwork standpoint!
Suppose you want to avoid all the hassle associated with issuing stock certificates and creating shareholder agreements. In that case, forming an LLC is the better option for your business needs.
The Pros And Cons
Here are the pros and cons of LLCs and S Corps.
Advantages Of Forming An LLC
Learning how to start an LLC means your personal assets are safe from any liabilities incurred by the company. You will also have flexibility in management structure, with no annual meetings or bylaws required.
Additionally, income/losses generated through the company pass straight to its owner's personal taxes - allowing pass-through taxation that many entrepreneurs take advantage of!
Disadvantages Of Forming An LLC
However, there are some drawbacks to forming an LLC as well. For instance, the business owner may incur additional costs with creating and maintaining an LLC. This extra cost depends on the state in which the corporation is registered.
In addition, because each state has different regulations regarding forming and operating an LLC, this can make it more challenging to do business across state lines.
Lastly, you may want to go public with your company at some point. In that case, you may need to convert your LLC into a C Corporation since most investors prefer investing in C Corporations over other structures, such as S Corporations or LLCs.
Advantages Of An S Corporation vs. An LLC
One significant advantage of forming an S Corp is taking part in fringe benefits such as health insurance, disability insurance, and retirement plans without having to pay taxes on those benefits. This advantage is not possible with LLCs since no employee-employer relationship exists between the members of an LLC.
Additionally, with S Corps, income can be distributed among shareholders as dividends rather than wages, which reduces the amount of self-employment tax paid on income.
S Corps also has a few other advantages over LLCs, including:
Disadvantages Of An S Corporation vs. An LLC
Compared to LLCs, owning an S Corp can be more expensive due to the additional paperwork and filing requirements. In addition, there are double taxation issues associated with S Corps which means income is taxed both at the corporate level and then again when distributed as dividends to shareholders.
Additionally, because of complex regulations, it is difficult for small business owners lacking experience in business law to properly set up and maintain an S Corp without help from a professional.
Another disadvantage of forming an S Corp over an LLC is that stockholders cannot transfer their ownership interests easily or freely. This process requires approval from the majority of other shareholders before individual investors can make any changes, which limits flexibility and control in terms of transferring shares of the company.
Lastly, S Corps are limited to a maximum of 100 stockholders, and all must be U.S. citizens or permanent residents. This factor differs from LLCs, which impose no such restrictions on membership.
The Basics Of Forming An LLC
Forming an LLC is no small feat. It requires research, paperwork, and plenty of patience. All before you can even consider applying for a federal LLC license and beginning operations.
If you're considering forming an LLC, here's a basic overview of the steps you will need to take to get started.
The first step in forming an LLC is choosing a name that meets state guidelines. Your name of choice must have yet to be taken by another business. It should reflect your company name or brand while being easy to remember and available for use.
Once you have chosen a name, it must be registered with the Secretary of State office where your business is located.
A registered agent for LLC must be appointed when forming an LLC; this person or entity serves as the main point of contact between the business and any legal notices from the government or other entities that may need attention from time to time.
The role of the registered agent is to receive important documents on behalf of the company, such as official notices or lawsuits, if applicable. To appoint a registered agent, fill out form SS-4 with the IRS for tax identification purposes and file it with your local Secretary of State office.
'Articles of Organization' are legally required documents filed with your local Secretary of State office. These documents outline basic information about your business, including member names, management structure, purpose, address, etc.
After filing these documents, at least one owner must sign them to be valid and accepted by the state government. This document also serves as proof that your LLC exists as far as state law is concerned, so it should be kept up-to-date at all times.
How S Corporations Can Help You Minimize Taxation
As a business owner, you want to ensure your taxes are as low as possible. One way to do this is by taking advantage of the pass-through feature of S corporations.
Pass-through taxation is a system where corporate income, losses, deductions, and credits are only taxed once individually when received as dividend income at shareholders' tax returns. This process means that any taxes incurred by the company are only calculated once and then passed through to the shareholders' individual returns.
Also, this helps to prevent double taxation scenarios and allows for lower overall rates for S corporation owners.
The major benefit of pass-through taxation is that it can help you save money on taxes while allowing you to take advantage of certain corporate benefits such as asset protection.
Additionally, you can use pass-through taxation to minimize your taxable income in other ways, such as by creating a retirement plan or charitable donation program through your corporation that allows you to deduct those LLC costs from your total taxable income.
Finally, if your business has losses or deductions, they can be applied against any profits, reducing the amount of money you have to pay in taxes for that particular year.
Filing Form 2553 With The IRS As An S Corporation
For your business venture to be recognized as an 'S' Corporation, you must take one last step – filing Form 2553 with the IRS.
Form 2553 is a document that needs to be completed and submitted to the IRS for your newly formed corporation to qualify as an "S" Corporation under Subchapter S of Chapter 1 of the Internal Revenue Code.
It's important to note that filing this form does not necessarily guarantee that your company will be eligible for Subchapter S status – but the process is necessary for your business venture to be considered by the IRS.
Once your business has officially been recognized as an "S" Corporation, you can enjoy some great benefits. For starters, any income earned by the company on its own (as opposed to income earned by individual shareholders) can be taxed at a lower rate than would otherwise apply under regular corporate tax rates.
Additionally, any losses incurred by the company can be used as a tax deduction for shareholders, which can help reduce their overall personal income tax rate.
Finally, if you have employees, setting up as an "S" Corporation allows you to provide them with retirement plans like 401ks or IRAs without having to pay unnecessary taxes on those contributions.
A Note On C Corporations
C Corporations offer more asset protection than LLCs, making them attractive for businesses seeking outside investment options or long-term stability.
C Corporations have detached tax filing requirements from their owners, meaning that any income earned by the corporation is subject to double taxation, first at the corporate level, then at the individual level when dividends are paid out.
Also, there is greater flexibility when transferring ownership shares in C corporations compared with other entities.
With C Corporations, owners are also eligible for certain tax credits and deductions unavailable to LLCs, such as the qualified small business stock (QSBS) exclusion. This advantage allows for long-term capital gains tax rates of 0% on qualifying sales of up to $10 million.
C corporations may also take advantage of particular research or development tax incentives from the federal government.
Overall, it's crucial to weigh all your options when deciding which type of entity is best for you and your business needs.
The Importance Of Compliance
No matter which form of entity you choose for your business, compliance with state and federal laws is essential.
Make sure you understand all applicable regulations before filing any paperwork or launching your venture – it's much easier (and cheaper!) to get everything right from the start than to try and fix mistakes later down the line.
It's also wise to speak with an experienced accountant to ensure you take full advantage of all the tax benefits available to your business entity.
What Is The Difference Between LLC and S Corp - FAQ
An S corporation offers some tax advantages that do not apply to an LLC. For example, an S corp is eligible for the pass-through taxation structure, meaning profits and losses are only taxed at the individual shareholder level rather than double-taxed as a corporation.
Additionally, an S Corp can offer shareholders more flexibility in taking deductions for business-related expenses and the ability to deduct losses from their personal taxes.
When paying yourself from an LLC, you are typically taxed at your individual income tax rate and will likely be subject to self-employment taxes.
With an S corp, you pay yourself a salary subject to payroll taxes, and any additional profits are passed through to the shareholders on their taxes as individuals. This process allows shareholders in an S corp to save money by avoiding double taxation.
The answer is that it depends on your specific business needs and situation. If you are looking for the most flexibility in taxation and deductions, then an S corp might be a better option.
On the other hand, if your goal is to protect yourself from potential liability issues that may arise from running a business, then an LLC might be better suited to meet those needs.
Conclusion
Understanding whether an S Corp or LLC is best for you and your business requires considering some factors. An LLC may be the way to go if you're looking for pass-through taxation, flexibility with ownership, and asset protection.
On the other hand, if you need more protection from creditors or are looking for long-term stability with potential tax incentives, a C Corporation might be the right choice. Ultimately, it is vital that you carefully analyze all the pros and cons before deciding which entity is best suited to your needs.
Setting your business up for success is essential, and understanding the differences between an S Corp and LLC is critical in making this decision. With a clear understanding of each entity's tax implications and benefits, you can make an informed choice that will help ensure your business has all the tools it needs to succeed.
