If you're starting a small business or considering changing your business structure, one important decision is whether to file as an S corporation (S corp) or a limited liability company (LLC). While the two are comparable, S corps and LLCs serve different purposes within a business’s legal and tax framework. This guide will help you understand these two options and determine which one is right for your business.
What is an S corp?
An S corp is a federal tax designation that allows qualifying businesses to pass both profits and losses directly to shareholders, who report that income on their individual tax returns. Due to the pass-through structure, S corps generally avoid federal corporate income tax. This type of designation is usually beneficial for small domestic companies.
To become an S corp, businesses must submit Form 2553, Election by a Small Business Corporation, signed by all the shareholders.
The advantages of becoming an S corp include:
- Pass-through taxation, in which shareholders report profits and losses on their individual tax returns. This advantage helps avoid the double taxation associated with C corporations.
- Limited liability extends to company directors, officers, shareholders, and employees.
- Perpetual existence, even if the owner leaves or passes away.
S corps have disadvantages for business owners, including:
- Complex compliance rules for shareholder payments, taxes, and more, with mistakes resulting in the loss of S corp status.
- The costs of incorporation may be a deterrent to some business owners.
- The requirements for maintaining S corp status can inhibit growth.
S corp eligibility requirements
To qualify for S corp status, a business must meet the following requirements per the IRS:
- It must be a domestic entity.
- It must not be an ineligible corporation. Certain financial institutions, insurance companies, and domestic international sales corporations are not eligible.
- It must have no more than 100 shareholders.
- Shareholders may be individuals, estates, or certain trusts. Partnerships and LLCs that are taxed as partnerships, corporations, or nonresident aliens are not eligible.
- It must have only one class of stock.
In addition to meeting these eligibility requirements, a prospective S corp must also file Form 2553, Election by a Small Business Corporation, with the IRS.
[Read more: 8 Types of Organizational Structures for Small Business]
What is an LLC?
Unlike an S corp, which is a tax designation, an LLC is a legal business structure. LLCs separate the owners’ personal assets from the company's assets, meaning owners are generally not personally liable for the LLC's debts or legal obligations.
Profits are passed directly to owners, who report the income on their individual tax forms. Under an LLC, there are no requirements for a board of directors, a certain number of shareholders, or domestic status.
The advantages of becoming an LLC include:
- Pass-through taxation for owners. The federal government taxes LLC businesses differently, depending on their structure. Single-member LLCs are taxed as sole proprietorships, while multimember LLCs are taxed as partnerships by default.
- Liability protection. LLC owners are typically not personally liable for business debts, protecting their personal assets.
- Management flexibility. An LLC allows management flexibility without the formal board and officer structure that corporations require.
[Read more: How to Write a Business Partnership Agreement]
The disadvantages of becoming an LLC include:
- Complexities around ownership changes. Depending on state law and the LLC’s operating agreement, the departure or death of an owner may require additional legal or administrative steps.
- A reduced likelihood of external investment. LLCs usually don't become publicly traded, so venture capitalists tend to invest in corporations rather than LLCs.
Tax implications of S corps vs. LLCs
Both S corps and LLCs offer pass-through taxation, meaning business profits are generally taxed at the individual level rather than the business level. But the key difference is in how each structure handles the owner’s income for tax purposes.
In a traditional LLC, owners generally pay self-employment taxes on their full share of the business's net earnings. With an S corp, owners who actively work in the business must receive a reasonable salary subject to regular W-2 payroll tax withholding, including self-employment taxes. Additional distributions are not subject to this tax.
Electing S corp status can help reduce the overall tax burden for owners, especially as their company becomes increasingly profitable.
S corp vs. LLC: Which structure is right for you?
Your specific business, financial, and lifestyle goals can help determine whether an S corp or an LLC is the right choice for you. Here are some key factors to consider:
- Ownership structure: LLCs generally offer greater flexibility in ownership, making them a good fit if you plan to add investors or owners over time. S corps are subject to IRS eligibility requirements, including limits on the number and type of shareholders.
- Management structure: S corps typically follow a more formal corporate structure with directors, officers, and recordkeeping requirements. LLCs offer more flexibility in how the business is organized and managed, requiring fewer administrative formalities.
- Taxes: S corps and LLCs both offer pass-through taxation. However, the potential to reduce self-employment taxes can make S corp status more attractive for a consistently profitable entity.
- Costs and administration: LLCs typically have lower startup and ongoing administrative costs. While electing S corp status does not require a filing fee, the payroll, tax filing, and compliance requirements associated with maintaining that status can increase ongoing expenses.
For additional or personalized guidance, contact a business consultant, attorney, or other legal professional.
Both S corps and LLCs offer pass-through taxation, but the key difference is in how each structure handles the owner’s income for tax purposes.
[Read more: Starting a Business? A Guide to Business Licenses and Permits]
When should I switch from an LLC to an S corp?
Many business owners initially structure their companies as LLCs because they’re flexible and relatively simple to manage. As the business becomes more profitable, however, some choose to elect S corp tax treatment while retaining the benefits of an LLC structure.
While there’s no universal income or profit threshold for making the switch, the decision often comes down to whether the potential self-employment tax savings outweigh the added costs and responsibilities.
Switching to S corp status may make sense if:
- Your business has consistent profits. If your profits are still low or unpredictable, staying with a traditional LLC is often simpler and more cost-effective.
- You can pay yourself a reasonable salary, commensurate with industry and geographic standards.
- You can manage the additional requirements associated with S corp status, including payroll, tax, and compliance. S corps tend to have stricter bookkeeping requirements, along with annual costs and state-specific reporting requirements.
How to make the switch
In most cases, eligible LLCs can elect S corp status with the IRS while remaining LLCs under state law. Here are the steps to convert from LLC to S corp taxation status:
- Confirm your business meets the IRS requirements for S corps. Your business must satisfy the eligibility requirements to elect S corp status and continue to meet them thereafter.
- Review state and operating agreement requirements. Before filing, review your state's rules and your LLC's operating agreement to determine whether any member approvals or additional filings are required. Ensure all owners agree to the S corp election before proceeding.
- File IRS Form 2553. The deadline to file Form 2553 and elect S corp status is typically March 15 of the applicable tax year.
Once the IRS accepts the election, any owners who actively work in the business must receive a salary through payroll. Consider consulting a tax professional to ensure your payroll systems and tax reporting procedures remain compliant with S corp requirements.
Katarina Betterton contributed to this article.
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