LLCs and S-corporations are often talked about together, but they are not an either-or choice. A limited liability company (LLC) is a legal business structure. An S-Corp. is a tax classification. You can elect to structure your LLC as an S-Corp., and many companies choose this option for tax advantages, but it’s important to know when and how these advantages apply.
Business entities and tax structures can be complicated. Understanding them can save you and your company time, money and potential headaches in the future.
LLC and S Corp.: Basic Definitions
An LLC is a legal business structure, while an S corporation is a tax structure. By default, an LLC is taxed as a partnership. However, you can also choose to tax an LLC as a corporation or an S Corp. Here are some factors to consider when making this decision and what’s involved in the process.
What Is an LLC?
An LLC, or limited liability company, is a legal business structure that protects the owner’s personal assets from the company’s debts. An LLC is considered a distinct entity, which means that there is a financial barrier between the company and the owner. The owners of an LLC are called members, and LLCs can be single-member or multiple-member owned. You can either elect members of the LLC or a manager to manage the company.
You can think of an LLC as a hybrid between a partnership and a corporation. LLCs are a common business structure for small and medium businesses and entrepreneurs because they are relatively easy to set up in comparison to other business structures and also provide legal protection that is not available to sole proprietorships.
“The LLC is the most recent form of entity that’s been available, and it started to get a lot more popular in the mid to late 1990s,” explained Chris Paris, a tax partner and CPA at the professional services firm Moss Adams.
LLCs are pass-through entities, which means the business structure does not pay its own taxes. Instead, the owner of the company claims the profit on their personal tax return.
To learn more about LLCs, including how to set one up, see our guide.
What Is an S Corp.?
An S corporation is not a business entity but a tax classification. Both LLCs and corporations can be structured to be taxed as an S Corp. An S Corp. is also a pass-through entity where the profit is passed through to the owner’s personal tax return. However, unlike an LLC, income that flows through an S Corp. is not subject to self-employment tax.
Both an LLC and S-corp provide limited liability. There are more restrictions for setting up an S Corp. than there are for an LLC. To form an S Corp., you must be a U.S. business and cannot have more than 100 owners. Owners of an S Corp. are considered employees and must pay themselves a reasonable salary.
LLC Vs. S Corp.: Similarities and Differences
An LLC and S-corporations are not an either-or comparison, but there are important differences to keep in mind when you’re thinking about setting up an LLC as an S-Corp.
Taxes
Because an LLC is a pass-through entity, profit does not get double taxed the way a corporation does. Instead, owners of an LLC are paid in distributions and report their income or loss on their personal tax returns, which is subject to federal, state and self-employment tax. Currently, the self-employment tax rate is 15.3%.
For example, say you’re the owner of an LLC that made an annual profit of $100,000. You would pay $15,300 in self-employment tax, in addition to state and federal tax. Owners of an LLC pay self-employment tax on the entire profit of the company. On the other hand, owners of an S-Corporporation. are considered employees. As an S-Corp. owner, you’re obligated to pay the employees (including yourself if you are the owner) a reasonable salary. This reasonable salary is subject to self-employment tax, but the company’s remaining profit is not.
This is where setting up an LLC as an S-Corp. can make a significant difference from a tax perspective.
The tax advantages are more complex than simply eliminating the 15.3% of self-employment tax. One way to think of it is that you’d be saving the 15.3% self-employment tax on the difference between the entire profit of your company versus the employees’ reasonable salaries. A reasonable salary must be based on standard salaries in your industry, your geographic location and your experience. In other words, it must be accurate and can’t be unreasonably low simply to take advantage of the tax benefits.
If your reasonable salary is $60,000 and the total profit of your LLC was $100,000, for example, you’d be paying $9,180 in self-employment tax as opposed to $15,300. If, on the other hand, your LLC has a total profit of $60,000, it may not be worth structuring it as an S-Corp., because your reasonable salary will be the same as the profit, and therefore you will be subject to the same self-employment tax.
Management Structure
An LLC can have an unlimited number of members, while an S-Corp. can have up to 100 owners.
Only individuals and certain trusts can be owners of an S-Corporation, Paris explained.
On the other hand, there is a lot more flexibility regarding who can own an LLC, including a C corporation or another partnership. Additionally, an LLC does not face as much regulation as a corporation.
“LLCs are a lot more flexible in terms of how you allocate the economics and amongst the owners, whereas corporations are more rigid,” Paris said.
With an LLC, you could have various classes of equity and various degrees of participation in your equity, Paris explained, unlike an S-Corp. where you can only have a single class of stock.
How to Structure an LLC as an S-Corp
There are two main steps to structure an LLC as an S-Corporation. The first step will be to elect to treat the LLC as a corporation. This means that the business structure is still an LLC under state law, but it is treated as a corporation for tax purposes. The next step will be to elect to treat the corporation as an S-corp, Paris said.
When Should Your Company Become an S-Corp.?
An LLC owner might want to become an S-Corp. for the tax advantages while avoiding dealing with the state law formalities of forming a corporation, which would require having officers, directors, board meetings and board minutes.
It could be a good time to consider becoming an S-Corp. when the company generates enough profit to make the change in tax structure worth it.
Disadvantages of an S-Corp
Because an S-Corp. will mean more complicated tax withholdings, you can expect your accounting fees to increase. An S-Corp. also requires separate tax filings. Therefore, it may only be worth operating an LLC as an S Corp. when your company reaches a certain income threshold, and the additional costs and fees make sense from an accounting perspective after you factor in employees’ reasonable salaries.
If you’re on the fence about whether or not it makes sense to structure an LLC as an S-Corp., it’s a good idea to speak to an accountant about the specific additional costs and the income threshold that justify the tax benefits of an S-Corp. If you are just getting started with your business and are still unsure about how much income your LLC will generate, you may want to consider holding off on setting it up as an S-Corp.
