Key Takeaways

  • An LLC offers flexibility in ownership and management, while an S Corp provides potential tax advantages via self-employment tax savings.
  • LLCs are generally easier to start and operate, but S Corps offer structured operations and investor appeal.
  • Choosing between LLC vs S Corp depends on income level, growth plans, and administrative preferences.
  • The IRS imposes specific restrictions on S Corps, including ownership rules and shareholder limitations.
  • A business can start as an LLC and later elect S Corp tax status for added tax efficiency.

S Corp for dummies will provide you with the basic information you need in order to identify if operating an S Corp is right for you. Businesses that want to incorporate are established as regular C corps and must elect to be taxed as an S Corp, which is also referred to as a special small business tax status election. In order to elect to be taxed in this manner, you will need to file Form 2553 (S Election Form) with the Internal Revenue Service (IRS) after the business is formed.

Keep in mind that S Corps are taxed as pass-through entities. This means that the profits and losses aren’t reported by the S Corp but are instead reported on the shareholder’s personal income tax returns. However, the S Corp must still file an informational tax return by filling out Form 1120s. Additionally, the business must also submit K-1 schedules, which report each shareholder’s income from the business.

Some, if not all shareholders in an S Corp can be employed by the business and pay themselves a reasonable compensation for the work done. Once you’ve elected to be taxed as an S Corp, the status will last for five years, after which point you must submit another form to continue being taxed as a small business corporation.

Key Features of a Corporation

Whether you operate an S or general C Corp, corporations have some typical key features, which is important to know before you choose to incorporate your business. First and foremost, corporations offer limited liability, meaning that the shareholders, officers, and board of directors are usually not personally liable for the business’s debts and obligations. The corporation has a perpetual existence, unlike the LLC. This means that the corporation will continue to operate even if someone leaves the business or dies.

The shareholders choose a board of directors who manage the business. The shareholders have various rights, including the right to:

  • Elect the directors
  • Inspect corporate records
  • Vote on important decisions of the business
  • Receive distributions

However, the shareholders will not have oversight over the daily operations of the business, as is the case with most LLC owners if they choose to operate a member-managed LLC. Corporations must maintain meeting minutes from all meetings held. Such meeting minutes should be signed by the directors and kept on file.

LLC vs S Corp for Dummies: Key Differences

When comparing an LLC vs S Corp for dummies, it helps to break down the differences in ownership, taxation, compliance, and flexibility:

1. Ownership and Structure

  • LLC: Can have unlimited members (including individuals, corporations, and other LLCs) and allows for flexible management structures (member-managed or manager-managed).
  • S Corp: Limited to 100 shareholders who must be U.S. citizens or residents. Only one class of stock is permitted, and ownership by other corporations or LLCs is not allowed.

2. Taxation

  • LLC: Default pass-through taxation. Members report income on personal tax returns. Self-employment taxes apply to all profits.
  • S Corp: Also pass-through, but allows owner-employees to take a “reasonable salary” subject to payroll taxes, with remaining profits distributed as dividends, which are not subject to self-employment tax.

3. Administrative Requirements

  • LLC: Fewer formalities. No required board of directors, shareholder meetings, or meeting minutes (though these can be adopted).
  • S Corp: Must follow strict corporate formalities, including maintaining minutes and adopting bylaws.

4. Flexibility

  • LLC: Greater operational and structural flexibility. Suitable for small businesses, startups, and real estate investors.
  • S Corp: Better for established businesses with consistent income and plans to pay salaries and distribute dividends.

5. When to Choose What

  • Choose an LLC if you want ease of use, minimal formalities, and flexibility in management and profit distribution.
  • Choose an S Corp if you’re earning steady profits and want to minimize self-employment taxes while maintaining a formal structure.

Compensation vs. Dividends

S Corps can pay dividends to their shareholders, which aren’t taxed as is the case with C Corporations. Therefore, Social Security and Medicare taxes are not paid on dividends. However, if a shareholder in an S Corp also does substantial work for the business, then they are also considered an employee and must pay themselves a reasonable salary. But what constitutes reasonable?

While there are several factors that you can consider when determining the appropriate amount to pay yourself in wages, remember that you cannot simply pay yourself through dividends in an attempt to avoid paying taxes altogether.

Generally, shareholder-employees in an S Corp will wait for profits to be above $50,000 annually before converting back to a C Corp.

For example, if you make $100,000 annually in profit, and pay yourself a $75,000 salary, then the remaining $25,000 would be paid to you in the form if a dividend. You’ll save $25,000 in taxes, but pay taxes on the $75,000 compensation. At some point, it makes more sense to operate as a C Corp, particularly if you have several employees with a very high profit.

IRS Restrictions

The IRS imposes some restrictions on S Corps, particularly when it comes to ownership. The following are those restrictions identified by the IRS:

  • The S Corp cannot have more than 100 shareholders, and can only issue one class of stock.
  • Shareholders must be natural persons, individual trusts, and/or tax exempt nonprofit organizations. Therefore, any other business structure, i.e. LLC or Corporation, cannot act as a shareholder in the S Corp. Nor can financial institutions or insurance companies act are shareholders.
  • The shareholders must be citizens or resident aliens of the U.S.
  • After all shareholders are chosen, they all must agree to the S Corp tax status.

Can an LLC Elect S Corp Status?

Yes, an LLC can elect to be taxed as an S Corporation by filing IRS Form 2553. This allows the business to retain the legal structure of an LLC while taking advantage of the tax benefits of an S Corp.

Why would an LLC do this?

  • To reduce self-employment tax burden.
  • To pay the owners a salary plus dividends, which may result in tax savings.
  • To position the business for investor appeal with a more formalized tax structure.

However, the LLC must meet S Corp requirements (e.g., limited to 100 shareholders, all U.S. citizens/residents, one class of stock). This election can offer the best of both worlds for many small businesses.

Frequently Asked Questions

1. What is the main difference between an LLC and an S Corp? An LLC offers flexible ownership and management, while an S Corp provides tax advantages by splitting income into salary and dividends.

2. Can an LLC be taxed as an S Corp? Yes, by filing Form 2553 with the IRS, an LLC can elect S Corp taxation to potentially save on self-employment taxes.

3. Is it better to start as an LLC or an S Corp? Many businesses start as LLCs for simplicity and later elect S Corp status once they are consistently profitable.

4. Are there income thresholds for choosing S Corp status? There’s no legal threshold, but it’s typically more beneficial when net profits exceed $40,000–$50,000 annually.

5. Can an S Corp have investors? Yes, but only up to 100 shareholders who must be U.S. citizens or residents, and only one class of stock is allowed.

If you need help learning more about S Corps or how to form an 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, Menlo Ventures, and Airbnb.