Tax Differences Between LLC and S Corp: Everything You Need to Know
There are several tax differences between an LLC and an S corporation. 4 min read
2. What are the Benefits of an LLC?
3. What Is an S Corporation?
4. What Are the Benefits of an S Corporation?
5. What if a Single-Member LLC is Taxed as an S Corporation?
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.
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.
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.
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.
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.
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