LLC vs S-Corp: Which Tax Structure Is the Best for You?
Choosing the right legal structure for your business is one of the most important decisions you can make as an entrepreneur. Registering your business as a limited liability company (LLC) or an S-Corporation are both popular options, but it’s important to understand the pros and cons of each of these business structures to make an informed decision.
Even though LLCs and S-Corps are often grouped together, they’re not mutually exclusive. A limited liability company is a business entity. In turn, an S-Corporation is a tax classification. Some entrepreneurs elect to have their LLC taxed as an S-Corp, but it’s crucial to do your research to figure out whether that’s the right step for you.
☕In this article, we’ll unpack the similarities and differences between an S-Corp and an LLC so you can make the best decision for your small business.
Key Takeaways
An LLC is a business structure and an S-Corp is a tax classification. You can elect to have your LLC taxed as an S-Corp.
Limited liability company (LLC) and S-Corp differ in significant ways, including self-employment tax obligations and management structure.
Having your LLC taxed as an S-Corp can potentially help you save money on taxes, but every business is different and it’s important to do your own research.
What Is an LLC?
A limited liability company, or an LLC, is a hybrid business structure that combines the flexibility of a sole proprietorship with the liability protections of a corporation. Many entrepreneurs and small business owners decide to form an LLC because it protects your personal assets but doesn’t face as many regulations as a corporation does.
For tax purposes, an LLC is classified by the IRS as a “disregarded entity.” This means that by default your limited liability company will be treated as a sole proprietorship for federal income tax purposes. In this case, your business profits will “pass through” to your personal tax return.
However, some business owners decide to have their LLC taxed as an S-Corporation. This route offers several advantages, but not all businesses qualify for the S-Corp tax status.
What Is an S-Corp?
An S-Corporation, or an S-Corp, is a tax classification that’s often used by entrepreneurs and LLC owners who want to enjoy corporation-level liability protection and potentially save money on taxes.
Similar to an LLC, an S-Corp is eligible for pass-through taxation. In contrast with a traditional C-Corporation, your business profits are not taxed at the company level. Instead, they pass through to the S-Corp owner’s personal income tax return. S-Corp owners are called shareholders.
💡As a shareholder, you will be treated as your company’s employee and will have to pay yourself a salary. This can potentially help you save money on taxes. In contrast, LLC owners have to pay a self-employment tax because they’re not employed by their LLC.
What Are the Requirements for Forming an S-Corp?
Not all LLCs qualify for the S-Corp tax classification. Your LLC must pass the following requirements to be considered an S-Corp for tax purposes:
It must be a U.S. business entity
It can’t have more than 100 shareholders (owners)
Shareholders must be US citizens or residents
Shareholders can’t be corporations or partnerships
The stock of all shareholders must be the same type
If you fulfill the requirements above, you should be able to qualify for the S-Corp tax status.
What Are the Similarities Between S-Corp and LLC?
Both S-Corps and LLCs provide personal liability protection and allow their owners to take advantage of pass-through taxation.
Whether you run an LLC or an S-Corporation, your personal assets and liabilities will be separate from your business assets and liabilities. This means that your personal property, such as your house or car, are not at risk if your business has debts or faces legal action.
Pass-through taxation is also a major advantage of both S-Corps and LLCs. In contrast with traditional C-Corporations, you’re not going to be taxed twice on your company profits. C-Corps have to pay taxes on both business and shareholder levels while S-Corp and LLC owners can report business profits and losses on their personal income tax return.
What Are the Differences Between S-Corp and LLC?
There are several key differences between S-Corps and LLCs that entrepreneurs should be aware of. Ultimately, it’s your choice as the business owner to decide which tax structure serves you best.
LLC vs S-Corp: Tax Differences
Both LLCs and S-Corps are pass-through entities for tax purposes, which means that you can report your business profits via your personal income tax return. However, self-employment taxes is where an LLC and an S-Corp start to differ.
LLC owners are considered to be self-employed. Each owners’ profit share is subject to federal, state, and self-employment taxes. The self-employment tax includes the social security and medicare taxes. In 2023, the self-employment tax rate is 15.3%.
As an S-Corp shareholder, you become an employee of your business and get paid a reasonable salary. You’ll still have to pay social security and medicare taxes, but it’ll only be from your salary, not all of your company profits. As a result, electing to have your LLC taxed as an S-Corp can help you save money during tax season.
LLC vs S-Corp: Tax Example
Let’s say you run a single-member LLC (you are the only owner) and your business made $100,000 in annual revenue. By default, you’ll have to pay self-employment taxes on the entire $100,000.
In an alternative scenario, if your LLC is treated as an S-Corp for tax purposes, you’re only liable for social security and medicare taxes on your salary. Let’s say your salary is $60,000 a year. In this case, you’ll only need to pay the social security and medicare taxes on the $60,000 instead of the entire $100,000.
Keep in mind that your salary must be reasonable. You can’t set it unreasonably low to claim tax benefits. The IRS checks your salary against various factors, including average salaries for your industry and your location. It’s important to be truthful about the amount of money you’re paying yourself.
LLC vs S-Corp: Other Differences
LLCs and S-Corps also have various other differences, including differences in ownership requirements, management structures, and reporting requirements.
Ownership: S-Corps impose restrictions on who can be a shareholder. Shareholders must be US citizens or legal residents and there can’t be more than 100 of them. LLCs don’t have such requirements.
Management: LLCs have a more flexible management structure than S-Corps. Your LLC can be either member-managed (when it’s run by its owners) or manager-managed (when you appoint a manager to run your LLC for you). In contrast, S-Corps are required to have a board of directors and corporate officers.
Reporting requirements: S-Corporations face additional reporting requirements and typically need to adhere to certain formalities, such as extensive record keeping and regular meetings.
In short, running an LLC is typically more straightforward than running an S-Corp, but tax benefits can make forming an S-Corp worth it for some entrepreneurs.
S Corp vs LLC: What’s Better?
Both LLCs and S-Corps have their advantages and disadvantages, and they’re not necessarily mutually exclusive. Which tax structure is better for your small business depends on your particular goals and circumstances.
Advantages of LLC over S-Corp
✔️Flexible management: You can manage your LLC yourself or appoint a designated manager. You don’t need to have a board of directors the way you do with an S-Corp.
✔️Fewer formalities: LLCs don’t have extensive reporting or meeting requirements. S-Corps do.
✔️No ownership requirements: You don’t need to be a US citizen or legal resident to start an LLC. An LLC can also have more than 100 shareholders.
Advantages of S-Corp over LLC
✔️Lower self-employment taxes: S-Corp owners don’t need to pay social security and medicare taxes on profits that are not their salary. LLC owners have to pay self-employment taxes on all their business profits.
✔️Unlimited lifespan: You may need to dissolve your LLC after it exists for a certain period of time. In contrast, S-Corps exist indefinitely.
✔️Heightened credibility: Running an S-Corp can signify to your clients and partners that you’re serious about your business.
Should I Switch From LLC to S-Corp?
Electing to have your LLC taxed as an S-Corp can be a good idea for businesses that generate enough income to pay the owner a salary and save money on self-employment taxes. Some businesses start out as LLCs and then decide to be taxed as an S-Corp.
Making Your Decision
Weighting the pros and cons of being taxed as an LLC and as an S-Corp can be complicated. It’s an important decision to make.
If you want to speak with a tax professional who can help you figure out how to create more tax savings for your business, get in touch with Desi Tax Service!
