LLCs vs. S Corporations: What’s the Best Business Structure for Your Business?
The limited liability company (LLC) business structure has become a preferred entity type for small business owners. Its minimal startup and ongoing compliance filings, combined with the simplicity of pass-through taxation and the advantage of limited liability for the business's owners, make it an appealing option.
Entrepreneurs often ask me the question "How are an LLC and S Corporation different?" As both are pass-through tax entities, I understand why it can become confusing to discern the differences between them. Learning about how they differ can help you determine the best business structure for you.
What is a limited liability company?
I like to describe the LLC structure as a cross between a sole proprietorship (or partnership) and a C Corporation. Because an LLC is its own independent legal entity, its owners’ (which are called members) personal assets are shielded from the debts and legal claims against the business. Under most circumstances, LLC members may only be held responsible up to the value of their investment in the entity.
This is also how an LLC is similar to a C Corporation—a corporation’s shareholders usually are not liable for the debts and legal claims against the company.
How are an LLC’s income taxes handled?
From a tax perspective, an LLC is by default treated as a sole proprietorship or partnership (if multiple owners). Its income and losses pass through to the business owners' personal income tax returns. The business entity does not pay or file a tax return independently. LLC members must pay not only income tax (at their individual tax rate) on their business profits but also self-employment taxes (SECA).
An LLC’s members are not considered employees. Since the company cannot put members on payroll, owners must personally pay the required funds into Social Security and Medicare. This is different than when an individual works for an employer, with the company and the employee each paying half of the FICA taxes (Social Security and Medicare taxes collected through payroll).
Alternatively, LLCs may opt for taxation as a C Corporation, whereby the business pays and files its own income taxes. This tax option means that business owners only pay Social Security and Medicare taxes (half of the FICA taxes) on the wages and salaries they receive from the business. The income the company pays them through profit distributions is subject to income tax, but not FICA.
Being taxed as a C Corp results in a "double taxation" situation, which might not prove financially advantageous. Some of a C Corp’s profits get taxed twice: once at the corporate level and then again at the individual level when paid to shareholders as dividends.
Eligible LLCs also have the option of electing S Corporation tax treatment, which avoids the C Corp double taxation and potentially delivers other benefits as well.
What is an S Corporation?
An S Corp is not a type of business entity—it’s a special tax election that an eligible limited liability company (LLC) or C Corporation may choose. In other words, business owners must decide whether their company will form as an LLC or a C Corporation before they elect for S Corporation tax treatment.
S Corp tax treatment may help LLC members decrease the amount they pay in Social Security and Medicare taxes, and like LLCs, S Corporations get pass-through taxation. However, unlike LLC default taxation, not all S Corp profits are subject to self-employment taxes. LLC members who work in the business are on the company payroll and will only pay Social Security and Medicare taxes on the income they receive as salaries or wages (half is paid by the individual and the other half by the LLC). Income paid to members as profit distributions are subject to income tax, but not self-employment taxes.
LLC members should be careful, though. If an LLC pays its members unreasonably low wages so that members can take the majority of money as distributions to avoid paying Social Security and Medicare taxes on that income, it could raise red flags with the IRS and other tax authorities.
More articles from AllBusiness.com:
- What Are the Potential Advantages of an S Corporation?
- 5 Things to Know About the Upcoming S Corporation Election Deadline
- Is S Corporation Election Right for My Business? It Depends on Your Business Structure
- The Pros and Cons of S Corporations
How to form an LLC
The steps to establishing a limited liability company vary by state. Generally, here's what's involved:
- Decide on a business name.
- Designate a registered agent (i.e., an "agent of process" authorized to receive legal paperwork and government notifications on behalf of the business entity).
- File Articles of Organization with the state.
- Obtain an EIN from the IRS.
- Apply for any required licenses and permits.
- Comply with ongoing business compliance responsibilities (e.g., maintain a registered agent, file annual reports, keep business finances separate from owners’ accounts, and be aware of any other federal, state, or local requirements).
How to get S Corporation tax treatment
An LLC can elect S Corp tax status by filing IRS Form 2553 (Election by a Small Business Corporation), signed by the LLC’s members. However, keep in mind that there are restrictions on eligibility, so not all LLCs may qualify for S Corporation election. The IRS lists the following criteria that must be met:
- Be a domestic corporation (or an entity eligible to elect to be treated as a corporation)
- Have only allowable shareholders
- May be individuals, certain trusts, and estates
- May not be partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)
2021 deadline for LLCs to apply for S Corporation election
For S Corp tax treatment to be in effect for 2021, existing businesses must meet the IRS deadline of March 15, 2021 to file Form 2553. Missing the deadline means the company will continue to be taxed as an LLC for the remainder of the 2021 tax year, with S Corp treatment kicking in on January 1, 2022.
Newly formed LLCs (and C Corporations) have two months and 15 days (75 days) from their date of formation to file for S Corporation election for tax year 2021.
Business owners can request a six-month extension to file for S Corp status by filing IRS Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns).
Expert advice to help you choose the best business structure
I encourage entrepreneurs to talk with legal and tax professionals when making decisions about business entities and tax matters. Many factors come into play, and every situation has its nuances to consider. Getting expert advice geared to your unique circumstances will help you choose the best business structure from the beginning and start your business on the right foot.
