S Corp vs LLC: Key Tax and Ownership Differences

Key Takeaways

• LLCs offer flexible ownership and pass-through taxation but may face higher self-employment taxes.
• S Corporations allow owners to take a reasonable salary and dividends, potentially reducing self-employment tax.
• Both structures provide liability protection, but S Corps have stricter IRS and ownership requirements.
• Choosing between an S Corp vs LLC depends on business size, profit distribution, and long-term growth goals.
• Single-member LLCs can elect S Corp taxation to optimize tax savings and maintain liability protection.

There are several tax differences between an LLC and an S corporation. The legal entity you choose for your business has a dramatic effect on many aspects of your business, including your potential liabilities, and the rate and type of taxation your business experiences. Your business structure can also affect aspects like financing and growth, as well as the number of shareholders and operations.

Aside from the legalities of the types of businesses that are codified at the federal level, there are also differences between the state laws when it comes to incorporating. Because this is so complicated, and it can have a serious impact on your business's future, it's best to contact an accountant or corporate lawyer to weigh your options for choosing a business entity.

S corporations and LLCs became more popular after the Small Business Protection Act of 1996. This included many changes to the corporate tax law, like allowing S corporations to hold stock in C corporations.

What Is an LLC?

The specific structure of an LLC depends on its operating state. But generally, an LLC is a type of business that is separate from the owners for tax and legal purposes. Its owners are referred to as members, and an LLC may have one or several members. 

An LLC allows you to protect your personal assets from any liability your company may incur. If there's a judgment against your company, you don't have to worry about your personal property.

Understanding LLC Taxation

LLCs are treated as pass-through entities for tax purposes, meaning profits and losses flow directly to the members’ personal tax returns. The IRS does not tax the LLC itself, avoiding the double taxation that C corporations face.By default, a single-member LLC is taxed as a sole proprietorship, while a multi-member LLC is taxed as a partnership. However, LLCs can elect to be taxed as a corporation or even as an S corporation by filing IRS Form 8832 or Form 2553, respectively.LLCs must pay self-employment taxes on all business profits since members are not considered employees. These taxes cover Social Security and Medicare contributions at a combined rate of 15.3%.

What are the Benefits of an LLC?

An LLC also has the advantage of the business not being responsible for its own taxes on profits, which is unlike the C corporation tax structure. In this case, the LLC's members report the profit and loss on their personal tax returns, just like a sole proprietorship or general partnership. This is a "pass-through" taxation, so there are no corporate tax returns. Members report their share of the profits and loss on their returns. 

Another benefit is that the LLC doesn't require residency. Members don't have to be U.S. citizens or permanent residents. This is why there are so many immigrant-owned businesses that are LLCs.

Though there isn't a financial component, an LLC also gives more credibility to its potential customers, partners, suppliers, and lenders who may view it more positively. Business owners usually opt for an LLC over a corporation because LLCs are more flexible in their management. They also have fewer recordkeeping requirements than corporations.

Potential Drawbacks of an LLC

While LLCs are popular for their flexibility and asset protection, they also have some disadvantages compared to an S corporation:

• Self-employment tax burden: Members pay Social Security and Medicare taxes on all profits, not just wages.
• State-level fees: Some states impose annual franchise taxes or reporting fees on LLCs.
• Limited investment options: Unlike corporations, LLCs cannot issue stock, making it harder to attract outside investors.
• Less tax savings for high-profit businesses: If profits exceed what would be considered a reasonable salary, an S Corp election may provide significant tax relief.

These drawbacks make it essential for business owners to review their expected income and long-term goals before forming an LLC or choosing S Corp status.

What Is an S Corporation?

An S corporation isn't really a business entity in the way an LLC or a C corporation is. This designation has more to do with the way the business is taxed. 

An S corporation is similar to an LLC in that its federal tax status is pass-through, and the taxable income or losses fall on the owners or investors, based on their ownership percentage. The IRS considers:

• Businesses partnerships
• Sole proprietorships
• S corporations
• C corporations. 

Because there isn't an LLC classification, LLCs have different types of taxation.

When choosing an S corporation status, a company can take away the double taxation of most corporate income and the shareholder dividends. An S corporation won't be taxed for its profit because the shareholders would simply pay taxes based on their percentage of ownership.

S Corporation Requirements

To qualify as an S corporation, a business must meet specific IRS requirements, including:

1. Being a domestic corporation or LLC.
2. Having no more than 100 shareholders.
3. Issuing only one class of stock.
4. Having shareholders who are U.S. citizens or resident individuals (certain trusts and estates also qualify).
5. Filing IRS Form 2553 to elect S Corp status.

These requirements ensure that S corporations remain small, closely held businesses that qualify for pass-through taxation. Failure to maintain compliance—such as admitting an ineligible shareholder—can lead to termination of S Corp status.

What Are the Benefits of an S Corporation?

An S corporation has the following benefits:

• Limited liability for officers, directors, shareholders, and employees.
• Pass-through taxation, in which owners report their share of the profit and loss on personal tax returns.
• Double taxation elimination.
• Investment opportunities.
• Perpetual existence, regardless of whether the original owner is still involved.
• Yearly tax filing requirement, as opposed to quarterly for a C corporation.

For many people, the biggest advantage is in the Medicare and Social Security taxes for the owners. These are self-employment taxes, and LLCs can generally save money by choosing to be taxed as an S corporation.

An S corporation also pays a fair salary to the working owner of the business. After that, any profits or losses continue to the owner's personal tax return. 

How S Corps Save on Taxes

One of the primary tax advantages of an S Corp is the ability to split income between salary and dividends. The IRS requires owners who work for their company to pay themselves a reasonable salary, subject to payroll taxes. However, distributions beyond that salary are not subject to self-employment taxes, potentially saving thousands annually.

For example, if an S Corp earns $120,000 and the owner’s reasonable salary is $70,000, only that salary is subject to payroll taxes. The remaining $50,000 can be distributed as dividends, which are not subject to Medicare or Social Security taxes.This tax-saving structure makes S Corps especially beneficial for profitable small businesses where owners actively participate in operations.

What if a Single-Member LLC is Taxed as an S Corporation?

In the event a single-member LLC is taxed as an S corporation, then:

• The member may be regarded as an employee and will receive a fair salary.
• The LLC can claim the salary as an expense. The owner reports both the salary and any additional profit.
• Unlike some other structures, an S corporation owner will only pay Social Security and Medicare taxes on his or her salary. 

Choosing Between an S Corp and LLC

When evaluating S Corp vs LLC, the decision often depends on profitability, number of owners, and administrative capacity.

• Choose an LLC if your business is new, has variable profits, or you prefer simple management and minimal reporting.
• Choose an S Corp if your business consistently earns profits beyond a reasonable salary, as you may save on self-employment taxes.
  However, S Corps require more recordkeeping, payroll filings, and IRS compliance. Owners must run payroll, issue W-2s, and file an annual corporate tax return (Form 1120-S).

Business owners can start as an LLC and later elect S Corp status when profits grow, offering flexibility while maintaining liability protection.

Frequently Asked Questions

1. Can an LLC become an S Corp?
   Yes. An LLC can elect S Corp status by filing Form 2553 with the IRS, provided it meets the S Corp eligibility criteria.
2. Which is better for taxes—an LLC or S Corp?
   For businesses earning moderate to high profits, an S Corp often provides better tax efficiency by reducing self-employment taxes.
3. Do S Corps pay self-employment taxes?
   No. Owners pay payroll taxes on their salary but not on profit distributions. LLC members, however, pay self-employment tax on all income.
4. Can an S Corp have multiple owners?
   Yes, up to 100 shareholders, as long as all are U.S. citizens or residents.
5. Do both LLCs and S Corps provide liability protection?
   Yes. Both structures shield personal assets from business debts and legal liabilities.

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