Choosing the right business structure is a crucial decision for any entrepreneur. Two popular options are the Limited Liability Company (LLC) and the S corporation (S Corp). Both structures offer unique advantages and disadvantages, and understanding these differences can help you make an informed choice. In this blog, we’ll explore the key distinctions of an LLC versus S corp to help you determine which is best for your business needs.

What is an LLC?

A Limited Liability Company (LLC) is a flexible business structure that combines elements of sole proprietorships and corporations. It provides liability protection for its owners, known as members, while allowing profits to be taxed at the individual level, avoiding double taxation.

Key Features of an LLC

1. Limited Liability Protection: Members of an LLC are protected from personal liability for business debts and claims, meaning their personal assets are typically not at risk.

2. Pass-Through Taxation: LLCs enjoy pass-through taxation, where business income is reported on the owners’ personal tax returns, and taxes are paid at the individual level. This avoids the double taxation faced by C corporations (taxed first at the corporate level (21%) and then again when owners have dividends or payroll).

3. Flexibility: LLCs offer flexibility in management and ownership structures. Members can allocate income or losses in a manner that makes sense for their business.

4. Fewer Formalities: LLCs have fewer regulatory requirements and formalities compared to corporations, making them easier and less expensive to maintain. I always recommend initially starting your business as an LLC and then making a change later on. LLCs are easy to start and easy to unwind. Especially, compared to other entity types.

What is an S Corp?

An S corporation (S corp) is a special type of corporation created through an IRS tax election. By electing to be taxed as an S corp, a company can pass corporate income, losses, and credits through to their shareholders for federal tax purposes. Shareholders of S corps report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corps to avoid double taxation on corporate income as well as avoiding LLC’s self-employment tax (approx. 14.13% on business profits). To qualify for S corp status, a business must meet several IRS requirements, including limitations on the number and type of shareholders.

Key Features of an S Corp

1. Limited Liability Protection: Like LLCs, S corps provide limited liability protection to their shareholders, shielding personal assets from business liabilities.

2. Pass-Through Taxation: Similar to LLCs, S corps also benefit from pass-through taxation. Business income is reported on the shareholders’ personal tax returns. This avoids the double taxation associated with C corporations.

3. Corporate Structure: S corps have a more rigid structure with formalities, such as a board of directors, annual meetings, and corporate minutes. This can provide credibility and structure but requires more administrative effort.

4. Salary and Dividends: Shareholders who work for the S corp must be paid a reasonable salary, which is subject to payroll taxes. Additional profits can be distributed as dividends, which are not subject to self-employment taxes, potentially reducing the overall tax burden.

LLC versus S Corp

Taxation

• LLC: Profits are subject to self-employment taxes (Social Security and Medicare) since the entire net income of the LLC is considered earned income.
• S Corp: Shareholders must take a reasonable salary, subject to payroll taxes. Additional profits can be distributed as dividends, which are not subject to self-employment taxes, potentially resulting in tax savings.

Ownership and Management

• LLC: Offers flexibility in management and ownership. You can have as many owners as you’d like, they can be foreign, and income can be allocated in any manner.
• S Corp: Requires a more formal structure with a board of directors and officers. Limited to 100 shareholders, and all must be U.S. citizens or residents.

Formalities and Compliance

• LLC: Fewer formalities and compliance requirements, making it easier to manage and less costly to maintain. They are easy to start and can be dissolved simply if the businesses ends operations.
• S Corp: S corps have more formalities and regulatory requirements. They require setting up payroll for owners, registering with various government agencies, and an additional tax return. They are more difficult and costly to set up as well as dissolve. 

Profit Distribution

• LLC: Profits are distributed based on the terms of the operating agreement, offering flexibility in how profits are shared among members.
• S Corp: Profits and losses are distributed based on the percentage of ownership, with less flexibility compared to an LLC.

Which is Right for You?

The choice between an LLC versus S corp depends on various factors, including your business goals, tax considerations, and administrative preferences. Here are some scenarios to help you decide:

Choose an LLC if:

• You want flexibility in management and profit distribution.
• You prefer a simpler, less formal structure with fewer compliance requirements.
• You are concerned about self-employment taxes but not enough to warrant the additional complexity of an S corp.
• Your business is making less than $70,000 per year, annually.
• You don’t plan to continue the business more than 2 years.  
• You are planning to have multiple partners with unequal ownership.

Choose an S Corp if:

• You want to minimize self-employment taxes through dividend distributions.
• You are comfortable with the formalities and regulatory requirements of an S corporation.
• Your business is going to make more than $70,000 per year, annually.
• You plan on being in business at least 3 years. You want the compliance set-up to be worth it.
• You don’t plan on having a ton of partners (more than 4 or 5) or partners have (approximate) equal ownership.

Conclusion

Both LLCs and S corps offer distinct advantages and are suited to different business needs. Understanding the differences in taxation, management, compliance, and profit distribution is crucial in making the right choice for your business. Consulting with a legal or tax professional can also provide valuable insights tailored to your specific situation, ensuring you choose the best structure for your business success.