If you're starting a small business or considering changing its structure, one important decision is whether to file as an S corporation or a limited liability corporation. 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 corporation (S corp) is a tax designation for businesses that are their own legal entities. S corps pass both profits and losses to the company's shareholders, who then report income on their individual tax returns. Due to the pass-through structure, S corps may reduce owners' liability. 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 eliminates corporate-level taxation on distributions beyond an S corp owner's salary.
- Limited liability is extended 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, which may be a deterrent to some business owners.
- The qualifications to maintain S corp status can inhibit growth.
[Read more: 8 Types of Organizational Structures for Small Business]
What is an LLC?
A limited liability company (LLC) is a structure that provides both protection and flexibility for business owners. LLCs are treated as corporations that delineate the owner's personal assets from the company's assets. That means, as an owner, you are not personally liable for the LLC's losses or debts.
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 not personally liable for business debts, protecting their personal assets.
- An LLC, allows management flexibility without the involvement of third parties, such as a board of directors, so owners have more control over how they manage the company.
[Read more: How to Write a Business Partnership Agreement]
The disadvantages of becoming an LLC include:
- Nonperpetuity, meaning the business may be dissolved if something happens to the owner.
- Reduced likelihood of external investment. LLCs usually don't become publicly traded companies, so venture capitalists tend to invest in corporations over LLCs.
Your specific business, financial, and lifestyle goals can help determine whether an S corp or an LLC is the right choice for you.
Tax implications of S corps vs. LLCs
Both S corps and LLCs offer pass-through taxation. This means these businesses do not pay income taxes, and profits are taxed at the individual level. By default, LLCs are taxed as sole proprietorships or partnerships, but LLCs may choose to opt out of pass-through taxation and be taxed as a corporation instead.
The major difference between how S corps and LLCs are taxed is whether its owners are subject to self-employment taxes. For an LLC, each member's share of income is subject to self-employment tax. S corp shareholders are not subject to self-employment taxes, but the IRS requires that owners who contribute significant services receive a “reasonable” salary, which is subject to payroll tax withholdings, like any W-2 income.
Despite the costs of incorporation and strict requirements for S corps, the tax cost savings of an S corp may outweigh the benefits of an LLC's simplicity.
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:
- Owner employment: Both options enable owners to be hands off, but S corps require that owners take a salary as an employee, while LLCs encourage owners to participate in the management of the organization.
- Ownership structure: S corps require owners to be individuals, certain tax-exempt organizations, or certain types of trusts with fewer than 100 owners — all of which need to be U.S. citizens or a U.S.-based trust. LLCs can have as many owners, or “members,” as they want or need with no classification or nationality requirements.
- Management structure: S corps choose a board of directors that elect officers to run day-to-day operations, while LLCs rely on managers to run the company. LLC managers can appoint officers if they would like to.
- Stock and shareholders: S corps can issue common stock to shareholders. Though LLCs can have membership interests, including financial and/or governance rights, they do not issue stock.
- Taxes: S corps benefit from pass-through taxation, meaning business profits are taxed at the shareholder level. LLCs can also be taxed as pass-through entities, though the owners can opt out and instead specify that the LLC be taxed as a corporation.
- Cost: Costs vary widely depending on the state the company will be based in, where the owner(s)/member(s) live, and whether the business hires an attorney. Though electing S corp status is free, incorporation fees can range from $100 to $250. Registering as an LLC can cost anywhere from $50 to $500.
For additional or personalized guidance, contact a business consultant, attorney, or other legal professional.
[Read more: Starting a Business? A Guide to Business Licenses and Permits]
When and how to switch from an LLC to an S corp
Many business owners initially structure their companies as LLCs. However, you are not locked into this choice forever, as you can convert your LLC into an S corp.
Converting to an S corporation may offer several benefits, including cost savings, as S corps are not required to pay self-employment taxes; stock options for both owners and employees who can be shareholders; and investments from other corporations that prefer working with S corps. S corps are formed in perpetuity, and their structure can often better accommodate growth and complexity.
Here are the steps to convert an LLC to an S corp:
- Meet the IRS' guidelines for S corps. Your company can have a maximum of 100 shareholders; you can only issue one type of stock; your business cannot be a financial institution, insurance company, or domestic international sales corporation; you must hold annual shareholder meetings with minutes kept and bylaws upheld; and shareholders must receive a reasonable salary.
- Check with your governing state. Not every state permits conversion, and some may offer statutory mergers instead. Once you have confirmation your business can be converted to an S corp, develop a plan that details the terms and conditions, and get approval from the LLC members.
- File for conversion. File a certificate of conversion with the secretary of state or other state filing office. Articles of incorporation and other legal documents may be required.
- Receive final approval and file tax forms. Ensure the new corporation directors and shareholders approve the S corp election and file IRS Form 2553.
Katarina Betterton contributed to this article.
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