Powell Tax Law Blog
LLCs vs. S Corps: Differences & Benefits of Each Corporate Structure
When starting a business, one of the first crucial decisions owners make is choosing the appropriate legal structure, with “limited liability company” (LLC) and “S corporation” (S Corp) the two most popular options.
It’s an important decision with wide-ranging implications.
“The business structure you choose influences everything from day-to-day operations to taxes and how much of your personal assets are at risk. You should choose a business structure that gives you the right balance of legal protections and benefits,” says the U.S. Small Business Administration (SBA).
Let’s examine the characteristics of LLCs and S Corps, highlight their differences, and explore the advantages and disadvantages of each. By understanding the nuances between these structures, you can make an informed decision that aligns with your business goals.
What is a Limited Liability Company or LLC?
Limited Liability Company (LLC) is a flexible and widely-used business structure that combines the advantages of partnerships and corporations.
It provides limited liability protection to its owners, known as members, shielding their personal assets from business liabilities. Here are some key aspects of LLCs:
- Limited Liability Protection: One of the primary advantages of an LLC is that it separates the personal assets of the members (such as vehicles, homes, and savings accounts) from the company's debts and legal obligations. If the LLC faces lawsuits or incurs debts, the members' personal assets generally cannot be used to satisfy those obligations.
- Flexible Management: LLCs offer flexibility in the management structure. Members can choose to manage the company directly, like a partnership, or they can appoint managers to handle day-to-day operations. This flexibility allows for efficient decision-making and streamlines the management process.
- Pass-through Taxation: By default, LLCs are treated as pass-through entities for tax purposes. This means that the LLC itself does not pay taxes. Instead, profits and losses are passed through to the members, who report them on their individual tax returns. This avoids the issue of double taxation, where both the company and its owners are taxed on the same income.
- Membership Interests: Instead of issuing shares of stock like corporations, LLCs grant membership interests to their owners. These membership interests represent the owners' stake in the company and their right to share in profits, vote on important matters, and participate in the management of the business.
SBA says that members of an LLC are considered self-employed and must pay self-employment tax contributions toward Medicare and Social Security.
“LLCs can have a limited life in many states. When a member joins or leaves an LLC, some states may require the LLC to be dissolved and re-formed with new membership — unless there's already an agreement in place within the LLC for buying, selling, and transferring ownership,” says the SBA.
What is an S Corporation or S Corp?
An S Corporation (S Corp) is a special type of corporation that has elected to be taxed under Subchapter S of the Internal Revenue Code. This election allows the corporation to enjoy pass-through taxation, like that of an LLC. Here are some key aspects of S corps:
- Limited Liability Protection: Like LLCs, S Corps provide limited liability protection to their shareholders. Shareholders' personal assets are generally shielded from the corporation's debts and legal obligations.
- Pass-through Taxation: The major advantage of an S Corp is its tax structure. Like LLCs, S Corps are pass-through entities for tax purposes. The corporation itself does not pay federal income taxes. Instead, profits and some losses are passed through to the shareholders, who report them on their individual tax returns.
- Ownership Restrictions: S Corps have certain ownership restrictions. They are limited to a maximum of 100 shareholders, and these shareholders must be U.S. citizens or residents. Additionally, S Corps cannot be owned by other corporations or non-resident aliens.
- Formal Structure: S Corps typically have a more formal structure compared to LLCs. They must comply with specific corporate formalities, such as holding regular shareholder meetings and maintaining corporate records. This structure can provide credibility and transparency, which may be advantageous in certain industries or when seeking investment.
“Not all states tax S Corps equally, but most recognize them the same way the federal government does and tax the shareholders accordingly. Some states tax S corporations on profits above a specified limit and other states don't recognize the S Corp election at all, simply treating the business as a C Corp,” says the SBA.
S Corps must file with the IRS to get S Corp status, a different process from registering with their state.
S Corps also have an independent life, just like C Corps. If a shareholder leaves the company or sells his or her shares, the S Corp can continue doing business relatively undisturbed.
Differences between LLCs and S Corps
Let's look at the differences between LLCs and S Corps in some key areas:
- Owner employment: LLCs allow flexibility in terms of owner employment, with members having the option to actively participate in the business. S Corps, on the other hand, require shareholders who work for the company to receive reasonable compensation as employees.
- Ownership structure: LLCs can have an unlimited number of members, including individuals, corporations, or other LLCs. S Corps, in contrast, is restricted to a maximum of 100 shareholders, who must be U.S. citizens or residents.
- Management structure: LLCs offer flexibility in management, allowing members to manage the company directly (“member-managed”) or appoint managers (“manager-managed”). S Corps have a more rigid management structure, with a board of directors and officers overseeing major decisions.
- Stock and shareholders: LLCs do not issue stock; instead, members have membership interests. S Corps issue stock to shareholders, who are typically subject to restrictions on ownership.
- Tax liability and reporting requirements: LLCs are generally subject to self-employment taxes, and members report profits and losses on their personal tax returns. S Corps are subject to corporate taxation but can avoid double taxation by distributing profits to shareholders as dividends.
Can an LLC be an S Corp?
Yes, an LLC can elect to be treated as an S Corporation for tax purposes by filing Form 2553 with the IRS.
This allows LLC members to benefit from pass-through taxation while still enjoying the limited liability protection of an LLC. However, the eligibility criteria for S Corp election must be met, including having fewer than 100 shareholders and meeting certain ownership requirements.
“While an LLC can elect to be taxed as an S Corp, it’s still classified as an LLC under state law and must comply with all the requirements and regulations governing LLCs in the state where it’s registered,” says Stripe. “On top of adhering to the requirements for LLCs, companies that opt for S Corp taxation might also have to follow additional regulations and requirements of S Corps. It can get complicated, which is why it’s important to work with a tax attorney and accountant to be sure your business is making the appropriate tax elections and fulfilling all associated requirements.”
Can an S Corp own an LLC?
Yes, an S Corporation can own an LLC. This can be a useful structure for businesses with multiple subsidiaries or diversified operations. The S Corp acts as the parent company, owning the LLC(s), which can provide additional liability protection and flexibility in business operations.
“If an S Corp owns an LLC, the LLC is considered to be a separate legal entity, and the S Corp’s ownership interest in the LLC is treated as an asset of the S Corp,” says Stripe. “The S Corp will report its ownership interest in the LLC on its tax return, and any income or losses generated by the LLC will flow through to the S Corp and be reported on the S Corp’s tax return.”
Benefits and Drawbacks of an LLC
There are advantages and disadvantages to any corporate structure that you choose for your business.
The main benefits of choosing an LLC structure are:
- Limited liability protection for members, separating personal assets from business debts.
- Flexible management structure and profit distribution.
- Pass-through taxation, avoiding double taxation at the corporate level.
The main drawbacks of choosing an LLC structure are:
- Self-employment taxes on profits.
- Limited ability to attract investment through the issuance of stock.
- Complexity in certain states regarding management and decision-making.
Benefits and Drawbacks of an S Corp
Choosing S Corp as your business structure presents a different set of benefits and drawbacks.
The main benefits of choosing an S Corp structure are:
- Limited liability protection for shareholders.
- Potential tax savings through the distribution of dividends, which are not subject to self-employment taxes.
- More established corporate structure and credibility for certain industries.
The main drawbacks of choosing an S Corp structure are:
- Stricter ownership and eligibility requirements.
- Restrictions on the number and type of shareholders.
- Compliance with formalities such as holding regular shareholder and director meetings.
How to Choose Between an LLC and S Corp
When deciding between an LLC and S Corp, consider asking the following questions:
- How many owners or shareholders will the business have?
- Will the owners be actively involved in day-to-day operations?
- What are the long-term goals for the business?
- Are you primarily seeking pass-through taxation or the potential for reinvestment and stock issuance?
- How important is flexibility in ownership and management structure?
- What are the specific legal and regulatory requirements in your state or industry?
- How do you envision the company growing and attracting investment in the future?
“LLCs can be a good choice for medium- or higher-risk businesses, owners with significant personal assets they want to be protected, and owners who want to pay a lower tax rate than they would with a corporation,” says the SBA. “S Corps can be a good choice for a business that would otherwise be a C Corp, but meet the criteria to file as an S Corp.”