Key Takeaways

  • LLC partnerships offer flexible ownership and management, while S Corps have stricter eligibility requirements.
  • LLCs are easier to start and maintain, but S Corps may provide payroll tax savings.
  • S Corps must follow stricter IRS rules, including reasonable compensation and shareholder limits.
  • LLCs can be member-managed or manager-managed, offering more operational flexibility.
  • State-level requirements, such as registration, fees, and reports, differ for LLCs and S Corps.
  • Electing S Corp status can offer tax benefits, but it comes with increased administrative complexity.
  • Business owners can switch from an LLC to an S Corp when growth or tax needs justify it.
  • UpCounsel can connect you with experienced business attorneys to help determine the right structure.

Understanding the differences between LLC partnerships vs. S corporations is important when you are setting up a new business or planning to change its structure.

Comparing LLCs vs. S Corporations

It's advisable to start your business as an LLC. You can elect for the S corporation status later. An LLC can switch over to S corp. status, but a company cannot start as an S corp.

For single-person businesses, there isn't much benefit in electing S corporation status. If it's a trading company, S corp. status may offer some tax benefits. However, if the entire business income comes from individual service, choosing S corp. status is disadvantageous. 

An LLC is a legal entity that is distinct from its owners. Owners of an LLC are called members. An LLC can have one or more members.

An S corporation is not actually a business entity. It's a special designation granted by the IRS for tax treatment. Compared to a corporation, an LLC offers more flexibility in terms of management, record keeping, and reporting requirements. That's why small businesses prefer to start out as an LLC rather than a corporation.

Not all businesses qualify for S corp. status. Though most single-member LLCs are eligible for S corp. election, the following are not:

  • A foreign LLC
  • An LLC owned by a nonresident alien
  • An LLC owned by a corporation or a partnership firm

Before electing the S corp. status for your LLC, consider whether the election would save you money and calculate the salary you would be entitled to. The salary you set for yourself should be reasonable since it must pass IRS scrutiny. The next thing to consider is whether there would be any business profit left after deducting your salary. If there would be no profit left, you cannot benefit from S corp. taxation.

S corp. taxation can save you money only if your business profits are more than your salary. Also, remember that structuring your business as an S. corp. could make your tax return a little more complicated since you may be legally required to withhold taxes.

Key Differences in Formation and Structure

When considering LLC partnership vs S Corp, the initial formation process and structural flexibility vary significantly:

  • LLC Formation: Typically involves filing Articles of Organization with the state and creating an operating agreement (especially for multi-member LLCs).
  • S Corporation Formation: Starts with creating a corporation or LLC and then filing IRS Form 2553 to elect S Corp tax status. This additional IRS step makes the process more complex.
  • Ownership Rules:
    • LLCs can have unlimited members, including individuals, corporations, and foreign entities.
    • S Corps are limited to 100 shareholders and cannot have foreign owners, other corporations, or partnerships as shareholders.
  • Management Flexibility:
    • LLCs can be member-managed (owners run the business) or manager-managed (designated managers handle operations).
    • S Corps operate with a board of directors and officers, even if there is only one shareholder.

How Are LLCs and S Corporations Taxed?

Businesses pay tax on net profit. LLC members include the business income in their personal tax returns based on their ownership percentage. 

For S corporations, however, the business profits that are leftover after deducting the owner-employee's salary pass through the owner's tax return. The salary that an owner-employee receives from his S corp. is added to his personal taxable income.

Payroll and Distributions

A critical distinction in the LLC partnership vs S Corp debate is how income is distributed and taxed:

  • LLC Members: Income is reported as self-employment income, subject to self-employment taxes (Social Security and Medicare).
  • S Corp Shareholders: Must be paid a “reasonable salary,” subject to payroll taxes. Any additional profits can be distributed as dividends, which are not subject to self-employment tax.

This structure can yield tax savings for S Corps if:

  • The salary is reasonable for the role.
  • There are sufficient profits beyond the salary for dividend distribution.

LLCs vs. S Corporations: Tax Benefits

For the purpose of taxation, there is no separate classification for LLCs. By default, a single-member LLC pays federal taxes as a sole proprietorship while a multi-member LLC is taxed as a partnership firm. However, an LLC can opt to be taxed either as a C corp. or an S corp.

When an LLC is treated as a sole proprietorship or as an S corp., the major difference lies in the levy of self employment taxes. Making the S corp. election may help you save on these taxes. Since income and expenses of an LLC flow through the personal tax return of the owner, he is considered self-employed and is hence liable to pay self-employment taxes on his income.

Just like self-employed individuals, employees are subject to Social Security and Medicare taxes. However, employers pay half of these taxes for their employees.

An LLC can deduct the salary it pays to its owner-employee as a business expense. The owner-employee, in turn, includes both the salary and his share of business profits in his personal tax return. Thus, the owner of a single-member LLC pays Medicare and Social Security taxes on all of his income, while S corp. owner-employees only have to pay taxes on their salary. 

When to Choose Each Structure for Tax Efficiency

Choosing between an LLC partnership vs S Corp should depend on your current income, business growth stage, and administrative capabilities:

  • Choose an LLC if:
    • You’re a startup or small business owner seeking minimal compliance requirements.
    • You prefer pass-through taxation without the need to manage payroll for yourself.
    • You want flexibility in profit distribution.
  • Choose an S Corp if:
    • Your business consistently earns more than what you would pay yourself in salary.
    • You want to save on self-employment taxes through dividend distributions.
    • You can manage the added complexity of payroll and IRS compliance.

LLCs vs. S Corporations: Similarities

  • Both structures offer limited liability protection.
  • Both are separate legal entities from their owners.
  • Both are pass-through entities for the purpose of taxation.
  • Both must comply with state-level formalities, like filing of annual reports and paying prescribed fees.

LLC vs. S Corporation: Difference in Ownership

  • Unlike S corps, there are no ownership restrictions for LLCs.
  • An S corp cannot have more than 100 shareholders, but an LLC can have any number of members.
  • An S corp cannot have non-resident aliens, other corporations, LLCs, partnership firms, and certain trusts as its members, but there are no such restrictions for an LLC.

State-Level Compliance and Formalities

Beyond federal tax considerations, state requirements also influence the LLC partnership vs S Corp decision:

  • LLCs:
    • Often require fewer ongoing formalities such as meetings or record-keeping.
    • Must typically file an annual report and pay a state renewal fee.
    • May be subject to state-specific franchise taxes or gross receipts taxes.
  • S Corps:
    • Must maintain corporate formalities like holding annual meetings and maintaining minutes.
    • In some states, S Corps may be subject to different filing fees or taxes than LLCs.
    • Shareholder restrictions apply at the federal level, but some states have additional nuances that affect eligibility.

Switching from LLC to S Corporation

An advantage of forming an LLC is the ability to switch to S Corp taxation later. This is beneficial when:

  • Your business revenue grows to a point where self-employment taxes become burdensome.
  • You're ready to pay yourself a salary and can afford the added bookkeeping responsibilities.
  • You're seeking to attract investors but want to retain the pass-through tax treatment of an S Corp.

To make the switch:

  1. Ensure your LLC qualifies under IRS S Corp eligibility rules.
  2. File IRS Form 2553 by the deadline (typically by March 15 for the election to take effect that year).
  3. Set up payroll for owner-employees and comply with withholding and tax reporting requirements.

Frequently Asked Questions

1. Can a multi-member LLC be taxed as an S Corporation? Yes. A multi-member LLC can elect S Corp status by filing Form 2553, provided it meets IRS eligibility requirements.

2. What are the disadvantages of an S Corp compared to an LLC? S Corps have stricter ownership rules, more formalities, and increased administrative costs, especially related to payroll and IRS compliance.

3. Which is better for self-employment tax savings, an LLC or S Corp? S Corps can offer better self-employment tax savings if the owner pays a reasonable salary and distributes the remaining profits as dividends.

4. Can I convert my LLC to an S Corp later? Yes. Many business owners start with an LLC and later elect S Corp status when the business becomes more profitable.

5. Do LLCs or S Corps have better liability protection? Both offer similar limited liability protection, shielding personal assets from business debts and lawsuits, assuming proper legal separation is maintained.

If you need help with determining the differences between LLC partnerships S corporations, 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, Menlo Ventures, and Airbnb.