LLC vs. S Corp: What's the Difference?

LLC vs. S Corp: An Overview

A limited liability company (LLC) is a type of business structure taxed like a partnership or sole proprietorship, where taxes are reported on the owners' personal tax returns, and any business liabilities belong to the business, not the owner.

An S corporation (S corp) is a type of business tax filing status that allows corporations to pass corporate income, losses, deductions, and credits through to their shareholders, but only if the business meets specific requirements. So, an LLC that meets the requirements for S corporation taxes could pass these items onto its shareholders rather than make the owners report them on their individual income taxes.

You can form an LLC and choose to be taxed as an S corporation. However, your business must meet specific guidelines set by the Internal Revenue Service (IRS) to qualify as an S corporation.

Key Takeaways

A limited liability company is a type of legal entity that can be chosen 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 often discussed side by side, they refer to different aspects of a business.
An LLC is a type of business entity, while an S corporation is a tax classification.
To be taxed as an S corporation, your business must first register as a C corporation or an LLC and meet specific guidelines set by the Internal Revenue Service (IRS) to qualify.

Limited Liability Company (LLC)

A limited liability company is a type of legal entity that protects the owner(s) from personal liability for debts and other obligations that a business might incur.

An LLC can be any company of any size in any industry.

Ownership of an LLC

An LLC can have an unlimited number of owners, commonly called "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 forming subsidiaries than other types.

LLC Business Operations

For LLCs, business operations are much simpler than other corporate structures, and the requirements are minimal. For example, some business types require that bylaws be adopted and annual meetings be conducted, but LLCs are not required to do so. LLCs merely adopt an LLC operating agreement, the terms of which can be very flexible.

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 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 tax return. An LLC with multiple owners would be taxed as a partnership, meaning each owner would report profits and losses on their personal tax return.

LLCs avoid double taxation because they pass all company income through to the tax returns of the individual owners. Double taxation is when a corporation pays corporate income tax, and the owners pay personal income taxes.

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 state's Office of the Secretary of State since they may have additional forms and requirements:

Choose a name
Assign a registered agent
File articles of organization
Create an operating agreement
Apply for a federal ID number
File business licenses and permits
Open a business bank account

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, a person or a company that handles any legal papers on behalf of the LLC if there is a lawsuit. Your state's Office of the Secretary of State should have a listing of local companies that can act as registered agents.

File Articles of Organization

You file these with your state's 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 is 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 you have more than one owner, you'll need to establish an employer identification number (EIN), a federal ID number that identifies the company. If you're a sole proprietor, you don't necessarily need an EIN unless you want it taxed as a corporation instead of a sole proprietorship.

File Business Licenses and Permits

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.

Open a Business Bank Account

It's critical that you not mix your personal and business finances. A business bank account, in addition to separating your finances, might make you eligible for lines of credit or loans you were not eligible for previously because your business finances (and credit) will not be linked to your personal finances.

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 for 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.

Pros

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.

LLCs are simpler to establish and operate than corporations. 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.

Another benefit of LLCs is that they are very flexible regarding their structure. There are no limits to the number of owners, 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.

Cons

One of the disadvantages of an LLC is when ownership needs an injection of cash or money. If the LLC had been 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. Also, there can be filing fees for forming an LLC and annual fees for filing annual reports.

Pros

Personal liability protection
No double taxation
Easier to establish and operate than a corporation
Flexible structure

Cons

More costly to establish than a sole proprietorship or partnership
Must file an annual report, and the fee can cost hundreds of dollars
Generally don't attract outside investment other than banks

The choice of business entity is going to be primarily guided by the nature of the business and how the owner envisions the business unfolding and growing in the future.

S Corporation

An S corporation differs from business types and structures in that it is a tax filing status, not a type of structure. A business must first register for incorporation in the state it chooses to operate from. Once it receives its letter of incorporation, it can file for S Corporation tax status with the Internal Revenue Service.

Below are some of the characteristics of S corporations.

Ownership of an S Corporation

The IRS is more restrictive regarding ownership for corporations that file for S corporation tax status. 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. While the companies that file for S Corporation status can be C corporations, LLCs, partnerships, or sole proprietorships, they cannot be owned by other S corporations, C corporations, LLCs, business partnerships.

S Corporation Taxation and Fees

S corporation status passes corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The S corporation shareholders 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.

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
Lawyer fees to process the legal documents
Annual reporting fees within the state
Accounting costs for financial reporting and tax services
Insurance costs

How to File for S Corporation Status

First, your company must already be formed and registered with your state's Office of the Secretary of State. Once you've received a certificate of incorporation showing that your business has been registered and incorporated, you must file form 2553 with the IRS. The form, called the Election by a Small Business Corporation, changes the company's tax reporting status if the Internal Revenue Service approves it.

Many states require that a registered agent be assigned to the S corporation. The agent should receive all legal documents and correspondence between state and federal agencies.

S Corporation Pros and Cons

There are distinct advantages and disadvantages to establishing and operating an S corporation. Some of the advantages include:

Pros

An S corporation does not pay federal taxes at the corporate level. As a result, an S corporation can help the owner save money on corporate or self-employment taxes.

An established S corporation can help boost credibility with suppliers, investors, and customers since it shows a commitment to the company and the shareholders.

Also, employees of an S-Corp can be shareholders, who are eligible to receive cash payments via dividends from the company's profits. Dividends can be an excellent incentive for employees and help the owner attract talented workers.

Cons

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 tax an S corporation as if it were a corporation. It's essential to check with your state's Office of the Secretary of State to determine how S corporations are taxed.

S corporations must be an existing business entity such as an LLC or C corporation to receive the tax status approval. So, they can be more cumbersome to establish and operate than sole proprietorships or partnerships.

Pros

Doesn't pay taxes at the corporate level, allowing pass-through to a personal tax return
Might pay dividends to shareholders
Lower taxes than LLC

Cons

Some states may tax S corporations as corporations; not at the personal level
S corporations must be established domestic companies before filing

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 attempting to make 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.

Choosing the right taxation method 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 an S Corp?

An LLC is a business structure where taxes are passed through to the owners. An S corporation is a business tax election in which an established corporation passes taxable income to shareholders. Which is better depends on the circumstances.

Who Pays More Taxes, an LLC or an S Corp?

It depends on how the business is established for tax purposes and how much profit is generated.

Why Would You Choose an S Corporation?

S corporations can help owners save money on corporate taxes by allowing them to pass taxable income to shareholders. This is useful for smaller businesses which have a limited amount of shareholders.

Should I Make My LLC an S Corp?

It depends on how your business is structured. If you have fewer than 100 shareholders, you can pass taxable income on to them and reduce your tax burden, but you'll need their permission. Also, you might want to analyze whether passing taxes onto shareholders is the best option for your business.

The Bottom Line

An LLC is a type of business structure that assumes the responsibility for company liabilities, rather than the owner being personally liable. Income is passed through the business to the owners, who report it on their individual tax returns.

An S corporation is an incorporated business that has elected to pass tax liabilities on to its shareholders.