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Determining the type of legal structure for a new business can be daunting for entrepreneurs and small business owners. Corporations and limited liability companies (“LLCs”) are preferred business structures because, unlike sole proprietorships and partnerships, both offer liability protection. This means that the owner of a company cannot be held personally responsible for the company’s debts. The personal assets of an owner are shielded from company liabilities.
In researching the various business structures, one inevitably comes across the S corporation. S corps and LLCs are similar in that they are both “pass-through” entities for tax purposes; the income of these companies are passed through to their owners and reported on the owners’ personal income tax returns, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation. (With a C corporation, the net business income is subject to corporate income tax, and the monies remaining after the corporate income tax are taxed a second time when they are distributed as dividends to its owners, who must then pay personal income tax.)
Table of Contents
So, what is the difference between an S corporation vs. LLC? Which structure is right for you?
The answer depends on your unique situation. If operational ease and flexibility are important to you, an LLC is a good choice. If you want to save on employment tax and your situation warrants it, an S corporation could work for you.
Business Ownership & Operation
There are restrictions on who can be owners (called “shareholders”) of an S corporation. An S corporation can have no more than 75 shareholders. None of the shareholders can be nonresident aliens. And shareholders cannot be other corporations or LLCs.
An S corporation is operated in the same way as a traditional C corp. An S corp. must follow the same formalities and record-keeping procedures. The directors or officers of an S corp. manage the company. An S corporation has no flexibility in splitting profits amongst its owners. The profits must be distributed according to the ratio of stock ownership, even if the owners may otherwise feel it is more equitable to distribute the profits differently.
LLCs offer greater flexibility in ownership and ease of operation. There are no restrictions on the ownership of an LLC. An LLC is simpler to operate because it is not subject to the formalities by which S corps must abide. An LLC can be member-managed, meaning that the owners run the company, or it can be manager-managed, with responsibility delegated to managers who may or may not be owners in the LLC.
And an LLC’s owners can distribute profits as they see fit.
Let’s say, for example, you and a partner own an LLC. Your partner contributed $40,000 for capital. You only contributed $10,000, but you performed 90% of the work. The two of you decide that, in the interest of fairness, you will each share the profits 50/50. As an LLC, you could do that; with an S corporation, however, you could only take 20% of the profits while your partner would take the other 80%.
Employment Tax: Savings vs. Paperwork
A major factor differentiating an S corporation from an LLC is the employment tax paid on earnings. The owner of an LLC is considered to be self-employed and, as such, must pay a “self-employment tax” of 15.3%, which goes toward Social Security and Medicare. The entire net income of the business is subject to self-employment tax.*
In an S corporation, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules. Therefore, there is the potential to realize substantial employment tax savings.
Case in point:
Mary owns a print shop. In keeping with the industry standard, Mary decides that a reasonable salary for a print shop manager is $35,000 and pays herself accordingly. Mary’s total earnings for the year are $60,000: $35,000 paid in salary, and the remaining $25,000 paid as a distribution from the S Corp. Mary’s total employment tax is $5,355 (15.3% of $35,000).
If Mary were the owner of an LLC, she would have to pay employment tax on the entire $60,000, equaling $9,180. But as an S corporation, she realizes $3,825 in employment tax savings.
One might assume that these savings could be further manipulated by reducing the salary to an extremely low amount and attributing the rest of one’s earnings to distributions — but this would be an incorrect assumption. In practice, the IRS carefully notices whether a salary is reasonable by industry standards. If it determines a salary to be unreasonable, the IRS will not hesitate to reclassify distributions as salary.
Still, while the potential employment tax savings may make the S corporation an attractive structure for your business, bear in mind that you would then have to deal with all the paperwork associated with payroll tax. The payroll tax is a pay-as-you-go tax that must be paid to the IRS regularly throughout the year–on time, or you will incur interest and penalties. The paperwork alone can be an overwhelming task for someone who is not familiar with this; and if you expect to incur losses or otherwise experience a cash flow crunch during the year that would hinder you from paying the payroll tax when due, this could present a problem.
LLC owners pay their self-employment tax once a year on April 15, when income taxes are normally due. Income tax filings are also relatively easy for the owners of an LLC: A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor; partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.
The comparison chart below sums up the similarities and differences between the two business structures:
S Corporation vs LLC
S Corporation (S Corp) | Limited Liability Company (LLC) | |
---|---|---|
Liability Protection | Yes | Yes |
Operational Control | Board of Directors/ Officers | May be member-managed or manager-managed |
Federal Income Tax | Pass-through | Pass-through |
Flexibility/Ease of Operation | No; subject to some formalities and record keeping rules as traditional C corps | Yes |
Ownership Restrictions | Yes | No |
Flexibility in Profit-Sharing | No | Yes |
Employment Tax | Employment/payroll tax on salary; no employment tax on dividends paid to shareholders | Self-employment tax on total net income * |
There is no one magical entity that works for everyone. A CPA or a specialized tax attorney can assist you in choosing the right structure for your business. It is important to consider each structure’s operational, legal, and tax aspects as they apply to your unique situation.
* For the tax year 2023, the self-employment tax rate remains at 15.3%. This rate comprises two parts: 12.4% for Social Security and 2.9% for Medicare. It’s essential to keep this updated tax rate in mind when considering your business structure and tax obligations.
For 2023, the first $160,200 of your combined wages, tips, and net earnings are subject to any combination of the Social Security part of self-employment tax, Social Security tax, or railroad retirement (tier 1) tax. (Source: IRS)
*For those who prefer the tax treatment of an S corp but like the simplicity of an LLC, there is an alternative worth considering: Forming an LLC that is taxed as an S corp. An LLC may make a special election with the IRS to be taxed as an S corp. This election is made on IRS Form 2553 and must be filed with the IRS before the 16th day of the third month of the tax year in which the election is to take effect.
An LLC that is taxed as an S corp is still a limited liability company from a legal standpoint (subject to the laws governing limited liability companies in the state of formation); however, for tax purposes it is treated as an S corp.
A word of caution: Certain nuances of S corp taxation can be confusing to some LLC owners, especially do-it-yourselfers and/or those who prepare their own tax returns; for example, an LLC owner might easily make the mistake of referring to an IRS publication that addresses LLCs when, in fact, such a publication would not apply to an LLC that is taxed as an S corp–and such an error could lead to negative tax consequences. It is therefore highly recommended that you consult a CPA or other qualified tax professional for advice and/or assistance.
Recommended Books on S Corporation vs LLC:
- LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
- S-Corporation: Small Business Start-Up Kit
- LLC or Corporation?: How to Choose the Right Form for Your Business
- The Operations Manual for LLCs (Entrepreneur Magazine’s Legal Guide)
- The LLC and Corporation Start-Up Guide (Quick Start Your Business)
Original Publication Date: January 2004. Updated on December 21, 2019
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In forming a LLC in Connecticut is it a necessity to publish it in a local newspaper before doing so?
Thank you for visiting PowerHomeBiz.com. There are no publication requirements in Connecticut when forming an LLC. I suggest you check out the process of forming an LLC from CT’s government-created website http://www.ct-clic.com/FAQ/faqView.asp?FaqID=211&CategoryID=17 or contact the Connecticut Secretary of State office at (860) 509-6002 or crd@ct.gov.
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Kudos on your amazingly clear and well-written article. My practice is set up as a LLC however, a new client requires contractors to be S or C corps. I read about the ability for a LLC to pay taxes as a S corp but if that is not acceptable to my client, is it possible for me to convert my LLC to a SCorp?
” Hello,
Thanks for the insightful post. It will definitely help the people who are thinking of incorporating their business. Here is another useful link which will help you in choosing between a corporation and an LLC. ezincorporate.com/corporation-vs-llc
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Can you update this related to the new tax bill that is in Congress right now? Looks like it’s going to pass. Under the new proposed law, is the deduction for pass-through entities, LLC and S-Corp, the same? Will one entity be better than the other?
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