If you want your business income to pass straight through to your personal taxes, you’ll usually end up choosing between an S corporation and an LLC. As this blog explains, LLCs and S corporations have some things in common, but they also work differently in important ways. One might be a better fit for your business than the other, depending on what you need and what matters most to you.
Reasons you might choose an S corporation instead of an LLC:
- You want to take a salary
- You want to bring in investors more easily
- You like the corporate structure
- You want profits split based on what each person put into the business
Reasons you might choose an LLC instead of an S corporation:
- You want more flexibility in how the business is run
- You want freedom in how profits and losses are divided
- You want fewer rules and formalities
- You don’t plan to raise money from lots of investors or go public
- You want pass-through taxation
When all is said and done, you need to talk to a trusted business formation lawyer before you choose a business structure. This blog simply gives you a few things to think about while you’re weighing your options before your business launches.
LLCs and S Corporations That Have S Corp Tax Status
An S corporation is a regular corporation where the owners choose a special tax status called Subchapter S instead of the standard Subchapter C. Even though S corporations and C corporations are taxed differently, they are treated the same under state corporate laws as business entities.
A one-owner LLC is automatically taxed like a sole proprietorship. If an LLC has more than one owner, it is usually taxed like a partnership. LLC owners can also choose to have the business taxed like an S corporation by filing IRS Form 2553, or like a C corporation by filing Form 8832. No matter which tax option you pick, state LLC laws treat all LLCs the same.
How Are S Corps and LLCs Similar?
S Corps and LLCs are Distinct Business Entities
LLCs and S corporations are legally their own “person” in the eyes of the law. They exist separately from the people who own them.
A corporation is created by filing articles of incorporation with the state. To use S corporation tax rules, it must also file a special form with the IRS. An LLC is created by filing articles of organization with the state. If the owners want a different tax setup than the default, they also need to file a form with the IRS.
After they are set up, both S corporations and LLCs must keep a registered agent, file annual reports, stay in good standing with the state, follow business license rules, and handle similar ongoing requirements.
S Corps and LLCs Both Offer Limited Liability
Both LLCs and S corporations protect their owners from being personally responsible for most business debts. This is one of the biggest reasons people choose to form a corporation or an LLC instead of owning the business in their own name.
Corporations and LLCs are separate from the people who own them. This means the business, not the owners, is responsible for its own debts and problems. The most an owner can usually lose is the money they put into the business. But if you run your business as a sole proprietorship or general partnership, your personal assets can be taken to pay business debts, even if those assets have nothing to do with the business.
Both S Corporations and LLCs Provide Pass-Through Taxation
S corporations and LLCs both let the owners pay the taxes instead of the business. The business doesn’t pay income tax on its own. The money it makes or loses goes directly to the owners, and they put it on their personal tax returns. This avoids the double tax that C corporations face, where the company gets taxed and then the owners get taxed again on the money they receive.
Even though both S corporations and LLCs use pass-through taxes, the federal tax rules for each are very different. They are not taxed the same way.
LLC Advantages Over an S Corp
LLCs have fewer formal rules to follow.
Corporate laws, which apply to both S corps and C corps, require things like yearly shareholder meetings, regular director meetings, giving official notice, keeping minutes, and other formal steps.
LLCs don’t have these kinds of strict requirements, so they give owners more flexibility in how they run the business.
LLCs are easier to manage in different ways.
People like LLCs because the owners can choose how the business is run. The owners can manage it themselves, or they can appoint managers.
Corporations don’t work that way. They must be run by a board of directors, and the shareholders are not allowed to manage the day-to-day business.
LLCs give owners more freedom in how they divide profits and losses.
Unless the LLC chooses S corporation tax status, the owners can split the money in almost any way they agree on. It doesn’t have to match each person’s ownership percentage.
An S corporation has to divide profits and losses exactly according to each owner’s share of the business. For LLCs, flexible profit-splitting can be helpful when owners do different amounts of work or play different roles in the business.
Tax Filing is Easier
If you are the only owner of the LLC, the IRS treats the business and you as the same for taxes. You just put the business income or losses on your personal tax return. The LLC does not need to file its own tax return.
This easy tax setup only works if you are the only owner. If your LLC has more than one owner, the IRS treats it like a partnership. You then have to file a partnership tax return, even though the LLC still doesn’t pay taxes by itself.
Pass-Through Taxation Without the Limits of an S Corporation
One big benefit of an LLC is that it can use pass-through taxation without having to follow the strict rules that apply to S corporations, as long as it is taxed like a partnership.
To be taxed as an S corporation, a corporation must:
- Be a U.S. corporation.
- Have 100 or fewer shareholders.
- Have only one class of stock (though voting rights can differ).
- Have only certain types of owners, such as individuals, certain trusts or estates, and some tax-exempt groups.
These IRS rules always apply. If you break any of them at any point, you could lose your S corporation pass-through tax status.
An LLC can get pass-through taxation without following any S corporation rules. If it has one owner, the IRS can ignore it as a separate entity. If it has more than one owner, it can be taxed as a partnership. Either way, it avoids the strict limits placed on S corporations.
LLCs also give you more choices in how you want to be taxed. You can be taxed as a sole proprietor (if you’re the only owner) or as a partnership (if there are multiple owners). And if you want, you can file a form with the IRS and choose to have your LLC taxed like a C corporation or an S corporation instead.
A big warning here is that if an LLC chooses S corporation taxation, it must follow all the S corporation tax rules. Also, different states handle this choice in different ways. It’s very important to talk to a skilled business formation lawyer before making this decision.
S Corp Advantages Over an LLC
S corporations have some benefits that LLCs don’t. Since an LLC can choose S corporation tax treatment, these advantages mostly come from the general differences between how corporations and LLCs are set up and run.
Preferred by Certain Lenders and Investors
Corporations often find it easier to get outside funding. Some investors and banks prefer corporations over LLCs because corporations are usually easier to reorganize or raise new capital as the business grows. Many people also still see the corporate structure as more formal or prestigious.
C Corp Conversion is Easier
Another benefit is that it’s easy for an S corporation to switch to C corporation status. All you have to do is file a form with the IRS. Since state laws treat S corps and C corps the same, you don’t have to file anything with the state to make the change.
LLCs and corporations are completely different types of businesses. If you want to change an LLC into a C corporation, you can’t just file a simple form. You would have to merge the LLC into a corporation, use a legal conversion process, or close the LLC and start a new corporation.
Makes it Possible to Sell Stock or Go Public
You might choose a corporation instead of an LLC if you plan to raise money by selling shares, bringing in venture capital or private equity investors, or possibly taking the company public later on.
Contact Carson Legal Strategies Today
As you can see, both LLCs and S corporations have their own pros and cons. There isn’t one right answer for everyone when choosing between an LLC and an S corporation. The best choice depends on what you need and what you expect for your business. Talking with a business advisor is the best way to figure out which structure fits your situation.
Are you looking to form an LLC or an S Corp? Contact the business formation lawyers at Carson Legal Strategies by calling (301) 818-9559 or via the contact form on our website to schedule your confidential consultation with a member of our legal team.
