Choosing a business structure can feel like an official milestone, though you’ve probably felt like you’ve been making your mark since the day you served your first customer. Corporations and limited liability companies are different, though. With each, your business becomes a separate entity in the government’s eyes, with distinct legal, financial reporting, and governance requirements.
What you’ll learn
What you’ll learn
Key takeaways
- Limited liability companies (LLCs) and S Corporations (S Corps) give you tax options, while protecting your personal assets from business debts and legal actions
- LLCs and S Corps are similar, but the former doesn’t have to maintain as robust of a governance framework as the latter. For this reason, S Corps are often viewed as more sophisticated than LLCs by investors and creditors
- An LLC may pay taxes as a C corporation (C Corp) or an S Corp, but doing so entails complying with potentially burdensome IRS requirements
For some, understanding of all the details regarding sole proprietorships, C Corps, S Corps, and LLCs can make your head spin. Don’t worry — we’re here to strip away the legal jargon and make things easier to understand. We’ll do so by focusing on distinguishing between S Corps and LLCs and offering information on the other structures where sensible.
What is an S Corporation?
An S Corporation is a business that has chosen to incorporate — to exist as its own legal entity, separate from its owners. Because of that separation, owners’ assets are typically not at risk if the business incurs debts or goes bankrupt. As business structures go, corporations offer the strongest protection for owners’ personal assets. However, a traditional corporation — a C Corporation — faces what tax pros call “double taxation.”
C Corps pay income taxes on all profits at the corporate level. Then, when they pay dividends on their taxed profits, shareholders are forced to pay taxes on that money.
A corporation can opt out of this system by filing with the IRS to attain S Corp status. This avenue is possible, assuming the organization meets the following criteria:
- Maintains domestic corporation status
- Has no more than 100 shareholders
- Has only individual and allowable trust or estate shareholders
- Has only one stock class
That said, certain types of companies, including insurers, certain banking institutions, and domestic international sales corporations, are ineligible for S Corp status. If you have questions about eligibility, consult a tax professional or business attorney.
If you’re considering adopting an S Corp structure, but not sure whether it makes sense for you, you’re not alone. For actionable insights, we turned to Tom Brock, a licensed CPA and CFA charterholder with extensive experience advising small businesses.
What are the pros of an S Corp?
- An S Corp offers significant tax advantages, primarily through pass-through taxation, which allows income to flow directly to shareholders without being taxed at the corporate level. S Corp shareholders also have the potential to reduce self-employment taxes by striking an optimal mix between taking reasonable salaries (which are subject to payroll taxes) and taking distributions of income (which are not subject to self-employment tax).
- Additionally, an S Corp provides shareholders personal liability protection, which means shareholders have no personal responsibility for corporate debts or legal issues. An S Corp also offers individual shareholders the ability to transfer ownership shares relatively easily, thereby facilitating business continuity.
- Finally, an S Corp is typically perceived as more sophisticated than a sole proprietorship or LLC, largely due to the more robust governance framework it must maintain. In some situations, this perception can lead to more favorable outcomes with investors, creditors, and business partners.
— Tom Brock, CPA, CFA
On the other hand, Tom notes that there are some potential drawbacks that business owners should be aware of.
What is a disadvantage of an S Corp?
A key disadvantage of an S Corp is its strict governance framework. An S Corp is limited to 100 shareholders, all of whom must be US citizens or residents, and can only issue one class of stock. Additionally, an S Corp must adhere to various bureaucratic formalities, including establishing and adhering to bylaws, holding regular board meetings and maintaining detailed records – all of which can be cumbersome for small business owners.
Now that we have a basic understanding of the S Corp structure, let’s take a look at the features associated with a limited liability company (LLC).
What is a limited liability company (LLC)?
An LLC combines elements of corporations and partnerships. Like a corporation, it protects personal assets from liability for debts, but it doesn’t have to abide by the same governance criteria. For example, an LLC doesn’t have a board of directors. Its owners run the show. Corporate law refers to LLC owners as “members.” Unlike an S Corp, an LLC can have unlimited members.
That said, if you run your business solo, you can become a single-member LLC. Unlike sole proprietorships, which consider the person and business as the same legal entity, a single-member LLC ensures legal separation between you and your business, thereby protecting your personal assets in the event of business bankruptcy.
By default, an LLC functions as a sole proprietorship or partnership. Members receive their share of the business’s revenue as personal income and pay taxes as self-employed individuals. This means LLC members must pay self-employment tax, an obligation representing what would otherwise be the employing entity’s share of Social Security and Medicare tax.
That said, if you own an LLC, you may be able to reduce your self-employment tax by filing as an S Corp. You can then pay yourself a reasonable salary and only pay self-employment taxes on that salary – instead of your total profit.
We know this is a lot of information to absorb! This article is supposed to distinguish between S Corps and LLCs – and here we are seemingly conflating the two. In subsequent sections, we’ll shine some clarity on the taxation complexities.
For now, to glean some additional insights on the pros and cons of an LLC, we, once again, consulted with Tom Brock.
What are the pros of an LLC?
- Unlike a sole proprietorship, an LLC offers strong personal liability protection, shielding members’ personal assets from company debts and legal issues. An LLC also affords flexible tax treatment, allowing members to choose between C Corp-style taxation and pass-through taxation, whereby profits and losses are reported on the members’ personal tax returns.
- All of this is achievable with a relatively simple governance structure and fewer formalities than required by corporations. An LLC does not require extensive charters and agreements, board meetings or extensive record-keeping. Furthermore, an LLC has no ownership restrictions, allowing unlimited members, including individuals, corporations and foreign investors.
— Tom Brock, CPA, CFA
Now that we covered some of the positives that might get the attention from business owners, let’s get Tom’s take on the other side of the coin.
What is the biggest disadvantage of an LLC?
A key disadvantage of an LLC is the fact that LLC members must pay self-employment taxes on all business income. Relative to an S Corp (with shareholders that take income in the form of salaries and profit distributions), this can result in higher overall taxes. An LLC’s members can mitigate this competitive disadvantage by electing to file taxes as an S Corp, but the maneuver entails compliance work and results in heightened administrative complexity.
Tom’s insights relate to federal taxation, “but there are also notable drawbacks at the state level,” he says. “Some states impose franchise taxes or gross receipts taxes on an LLC, making this type of organization more expensive to maintain than other structures.”
Moving on, you may be wondering if there’s anything that these two structures have in common.
Similarities between S Corps vs. LLCs
You may have noticed that S Corps and LLCs aren’t mutually exclusive. For example, an LLC can register with the IRS as an S Corp and follow the taxation rules for an S Corp. This intersection may cause some curiosity regarding the similarities of the S Corp and LLC structures. We’ve touched on some of them in previous sections. Below, we bring some clarity to the subject.
S Corps and LLCs both have the following features:
- Recognition as a distinct legal entity: S Corps and LLCs are legally separate from their owners. They have their own legal names and abide by local, state, and federal regulations as companies.
- Personal liability protection: LLCs and S Corps protect owners’ assets from claims made against the business entity. This means owners’ have no exposure to bankruptcy actions or lawsuits, with select exceptions.
- Pass-through taxation: LLCs and S Corps can transfer profits to owners for tax purposes. They don’t have to pay corporate taxes; rather, the owners can be held individually responsible for paying income tax on their personal tax filings.
Next, let’s take a holistic look at how taxation works for these two types of entities.
Differences in taxation
The first thing to understand is that, by default, an LLC is either a partnership or sole proprietorship for tax purposes. A single-member LLC is automatically a sole proprietorship. If your LLC has two or more members, the IRS views it as a partnership.
In these scenarios, the IRS views LLC income as personal income. If your LLC is a partnership, you and your partner(s) will each file Form 1065, U.S. Return of Partnership Income. If you’re a single-member LLC, you file Schedule C for business income as a sole proprietorship.
In both cases, you’ll pay self-employment tax on all business income, but are eligible for other LLC tax benefits that sole proprietors don’t have — such as the potential ability to pay taxes as a C Corp or an S Corp. By electing the S Corp taxation option, your business will remain an LLC for legal purposes, but you’ll be positioned to pay yourself and other members a salary. You will have to pay self-employment tax on the salaries, but profits aren’t subject to that tax.
Keep in mind
Please note, if you actually incorporate your business, you officially become either an S Corp or a C Corp across the board. This prohibits you from filing your taxes as a sole proprietorship or partnership.
Compliance requirements
The most significant advantage of choosing an S Corp structure over an LLC structure is the ability to pay yourself a salary and reduce your overall tax burden. That said, this advantage can be eliminated by forming an LLC and electing to have it taxed as an S Corp.
If you choose to go with an S Corp, remember,, you’ll have to comply with some strict governance requirements, including those noted below.
- Creating corporate bylaws
- Holding annual shareholder and director meetings
- Maintaining detailed corporate records
- Issuing all stock shares at the same price
Furthermore, to maintain your status as an S Corp, you must continuously satisfy the eligibility criteria. If you fail to do so — for example, if you take on a 101st shareholder — you can no longer file taxes as an S Corp. You must file as a C Corp.If your business is an LLC and reaches a point where it no longer qualifies to pay taxes as an S Corp, you have the following three choices: Become a C Corp, file as a C Corp, but remain an LLC, or pay taxes as a partnership or sole proprietorship. Remaining as an LLC tends to be the most flexible option, but there’s no one “right” answer.
So, what’s the verdict? We asked Tom the question that’s on everyone’s mind, though, of course, everyone’s situation is different.
Is it better to start as an LLC or an S Corp?
If you value simplicity and flexibility, an LLC is likely the better choice. However, if you envision rapid growth, have the capacity to handle time-consuming compliance requirements, and prioritize minimizing your total tax burden, an S Corp may be more advantageous.
Making the final call can be difficult, and the optimal choice varies from one business to the next. Fortunately, you don’t have to lock yourself into the structure you choose. Many small businesses start as an LLC and later elect S Corp status as they grow their revenues and refine their operations.
— Tom Brock, CPA, CFA
S Corp vs. LLC: Each has a time and place
Different tax processes mean different payroll requirements. Whether you incorporate as an S Corp or go the LLC route, you’ll need to comply with all state, federal, and local requirements. OnPay makes it easy with user-friendly payroll software for businesses of all structures. Whether you’re an expert payroll processor or still learning about terms like gross pay vs. net pay, we’ll assist you in navigating payroll as an LLC, S Corp, or whatever business structure you choose.
Best of luck as you take your business to the next level and we are here to help with your payroll questions.
Take a tour to see how easy payroll can be.
Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.