Difference Between LLC and S Corp

Understanding the difference between LLC and S Corp helps you incorporate your business in the most tax efficient way possible.

What is an LLC?

The specifics surrounding an LLC depend on the state in which you operate; however, you can count on an LLC allowing you to separate the business's legal ties from the personal affairs of the owners, who are also called members. There's no limit to the number of LLC members, and you could even have just one. An LLC is often chosen by small business owners in order to gain greater management flexibility. You also have less extensive requirements for reporting and keeping records than you would as a corporation.

What is an S corporation?

An S corporation actually isn't a business entity like an LLC or even a C corporation. This designation actually references the way a business is taxed by the IRS.

S Corp. Vs. LLC: Which Should I Choose?

Both LLCs and S corporations share benefits that make them both good choices for business owners. Specifically, you get to take advantage of pass-through taxation as well as liability protection. With an LLC, you also manage to evade double taxation that you get with C corporations, which must pass the company's earnings on via individual owners' tax returns.

By choosing an S corporation, you can protect the assets of business owners another way. To avoid corporate liability, owners pass income through dividends, also allowing them to circumvent taxation from the corporate and personal sides. S corps and LLCs alike became more popular in 1996 with the passage of the Small Business Protection Act. This law changed many factors in basic corporate tax law. Most notably it allowed S corporations to hold any amount of C corporation stock, but C corporations can't hold any stock in S corporations.

The Similarities

LLCs and S corps do share several traits, including:

  • Owners not held personally responsible for any debt of liabilities from the business (called limited liability protection)

  • Both are their own legal entities through a separate state filing (called separate entities)

  • Share the trait of pass-through taxation. The difference is that an S corp requires a business tax return, while this is only necessary with an LLC if there is more than a single owner. No income taxes are paid for the business in these scenarios. Any profits and losses are reported through the personal tax returns of the owners. If taxes are owed, they're reported and paid by the individuals.

  • LLCs and S corps are both required to follow any state mandates like paying fees and filing an annual report.

Finally, both types of companies can deducts certain pre-tax expenses related to their business. This can include work-related travel, bills, office equipment, marketing, client gifts, and health care premiums.

Difference in ownership and formalities

There are certain restrictions from the IRS that come along with S corporations that aren't found with LLCs. The key differences include:

  • There's no limit to LLC members, but S corps can only have up to 100 owners/shareholders.

  • An LLC may have members who aren't U.S. citizens or residents, but S corp shareholders must by U.S. citizens or residents.

  • A C corporation cannot own an S corporation, nor can another S corp, LLC, trust, or partnership. LLCs have more flexibility here.

  • There are no restrictions on LLC subsidiaries.

Additionally, while LLCs are recommended to have certain internal formalities, there's no requirement. S corporations, on the other hand, have actual requirements. They include the adoption of bylaws, stock issuance, regular director and/or shareholder meetings, and complying with record keeping rules for meeting minutes. The recommendations for such LLC formalities include the adoption of an operating agreement, the issuance of shares for members, holding annual member meetings and documenting them, along with documenting major decisions related to the company.

Differences in management

The LLC's owners can elect to have the member manage the company or have managers. If the members to this, it's really like a partnership. When managers run the LLC, it acts more like a corporation because members don't deal with day to day operations.

Alternatively, S corps utilizes directors as well as officers. Board members take care of corporate affairs and large decision making responsibilities. They then choose officers to take care of the day to day business.

Existence

S corps are created in perpetuity while LLCs may have to list a dissolution date when forming, depending on the state's requirements. Automatic dissolution of an LLC can also occur from events like the death or withdrawal of a member.

Transferability of ownership

As long as an S corp meets IRS ownership restrictions, its stock can be transferred freely. LLC membership, on the other hand, cannot be transferred freely. Instead, you often need to get the action approved by other members.

Self-employment taxes

Self-employment taxes are often more favorable with an S corp rather than an LLC because the owner can be paid a salary just as an employee. Taxes for FICA are paid on the salary and therefore aren't charged as self-employment tax. On top of that, any corporate earnings beyond the salary can potentially be used as unearned income, so you don't have to pay additional self-employment taxes.

Formal Operational Requirements

While S corporations have strict structure requirements, LLCs aren't required to follow the same rules -- even if they're encouraged to do so. S corps must follow several formalities, like the adoption of bylaws, annual and initial meetings for shareholders, documentation of meeting minutes, and regulations concerning shares and how they're issued.

There aren't such strict requirements for LLC and their business operations. Instead of establishing in-depth bylaws, LLCSs just need an operating agreement. Even that is pretty lenient and caters to the preferences of the owners. Plus, LLCs don't have to create or keep on hand any type of records for company meetings and major decisions, so it's much easier to operate than an S corp in some ways.

Basic Management Structure

With an LLC, the owners get to choose if they want to run the details of the business or hire managers to do so. An LLC operates more like a partnership if the owenrs choose to hold management positions. S corps, on the other hand, must have both a board of directors as well as corporate officers.

It's the job of the board of directors to oversee the company's management as well as make any large decisions for the company. Meanwhile, the corporate officers include position like the chief executive officer (CEO) and chief financial officer (CFO). They take care of managing the daily business operations of the company.

Accounting Requirements

LLCs do come with certain accounting requirements. Primarily, they have to use accrual accounting rather than choosing cash basic accounting. There are some exceptions to this rule, but if you file as a corporation, you can choose whichever accounting type you prefer.

LLC Pros

If you're the only owner of a single member LLC, you don't need tax return specific to the LLC. Instead, you just report your business income on your personal tax return. LLCs are also easy because the setup forms are just a page long. Not only that, you'll likely only need to pay a couple hundred dollars to set up your LLC. And since the bureaucratic requirements aren't as strict as they are for S corporations, you can also save on attorney and accountant fees.

LLC Cons

For any earnings you bring in through your single member LLC, you'll have to pay self-employment tax. This can add up quickly and is paid through quarterly estimates to the IRS. Any differences between your estimates and actual owed taxes are reconciled when you file. Additionally, you need to keep your personal affairs separate from those of your LLC.

S Corp Pros

If you have excess profits in the form of distributions, you get access to tax benefits through an S corp. Owners can receive these dividends and receive a lower tax rate than their other income. Any employees must be paid a salary that is "reasonable," so it should have some connection to the norms of the industry. That means you get to deduct expenses related to payroll, like FICA and federal taxes.

S Corp Cons

Compared to LLCs, S corps have greater restrictions in terms of how the business is operated and started. In order to create an S corp, the IRS states you must meet the following requirements:

  • Have U.S. citizenship or residency

  • Have less than 100 shareholders

  • Have just one class of stock

  • Distribution of profits and losses proportionate to the shareholder's interest -- meaning if a shareholder owns 20%, she'll get 20% of the profits (or losses, if applicable)

Another con is that S corps are more expensive to startup compared to LLCs. Additionally, if shareholders don't adhere to any requirement at any given time, they could lose S corp status. That would result in the company being turned into a C corp, which has even more restrictions.

S corps must also limit their passive income, with a maximum of 25% of your gross receipts coming from activities like real estate investment. S corps are also potentially subject to state taxes. The IRS is also becoming increasingly diligent about ensuring shareholders pay themselves a "reasonable" salary for any work they do on behalf of the company.

What's the difference in how much it costs to maintain an entity as an LLC versus as an S Corporation?

Because an S corporation typically owes extra payroll and state taxes, their tax burden is usually higher than that of an LLC. Additionally, any owner's salary is charges state unemployment and disability tax. On the flip side, an LLC's individual owner doesn't have to worry about any payroll taxes. Of course, if the owner becomes unemployed or disabled, he or she doesn't get access to those benefits.

A lot of states also levy a corporate tax on entities including S corps, but not on LLCs. While historically S corps could get away with not paying any Social Security or Medicare tax on profits above their salary, the rules have since changed. In 2011, a new law dismissed this benefit for S corps.

It sounds like an S Corporation is more costly. Is there any reason that I should consider being an S Corporation?

For a freelancer working primarily as a contractor for a single client, the IRS may question the validity of the contractor status and argue that the person should actually be hired as an employee. With an S corp structure, however, the freelancer can sidestep and murky waters with the IRS since the corporate entity pays both unemployment and disability.

For people who forget to pay their quarterly estimates, an S corporation can help them avoid late fees by using a payroll service that automatically deducts their taxes.

Any other advice to make this complicated decision a little easier for new business owners?

If you're already an LLC, you can change your status to an S corporation for free. However, you can't do it the other way around, changing from and S corp to an LLC. If you're still not sure what's best for you, you can explore your options with a CPA.

If you need help learning more about the difference between LLC and S Corp, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.