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.

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.

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. 

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.

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