When entrepreneurs choose a legal entity and tax classification for their business, it’s best to familiarize themselves with all the available options to find the one that is best for the business in the long run. Read on to discover the difference between an S corp and an LLC, and how to determine which option may be best for your business.
What is an S corp?
An S corp (also known as an S corporation) describes a tax classification that “passes corporate income, losses, deductions, and credits through to shareholders for federal tax purposes.”
To become an S corp, businesses must meet certain criteria, including being a domestic corporation; having no partnerships, corporations, or nonresident alien shareholders; having no more than 100 shareholders; and having only one class of stock — among other requirements.
To become an S corp, businesses must submit Form 2553 Election by a Small Business Corporation signed by all the shareholders.
The advantages of becoming an S corp include:
- Pass-through taxation by shareholders reporting their profits and losses on individual tax returns.
- Limited liability extended to company directors, officers, shareholders, and employees.
- Perpetual existence, even if the owner leaves or passes away.
- The elimination of double taxation of income.
S corps also have disadvantages for business owners, including:
- The requirements to become an S corp limit who can incorporate as one.
- Complex compliance rules for shareholder payments, taxes, and more — with mistakes resulting in the loss of S corp status.
- The costs of incorporation may be a deterrent to some business owners.
- Qualifications to maintain S corp status can inhibit growth.
[Read more: 5 Types of Organizational Structures for Small Businesses]
What is an LLC?
A limited liability company or LLC is a business structure that offers the protection of a corporation, as well as the efficiency and cost of a sole proprietorship or partnership. LLCs are often easier to operate than traditional corporations because they don’t require a full board of directors, numerous shareholders, or strict guidelines to keep LLC status. According to the IRS, LLC regulations differ by state.
Your specific business, financial, and lifestyle goals can help determine whether an S corp or an LLC is the right choice for you.
The advantages of becoming an LLC include:
- Pass-through taxation for owners. The federal government taxes businesses differently, depending on the type of LLC (a single-member LLC, or SMLLC, versus an LLC between two or more individuals) they are registered as. In general, SMLLCs are taxed as a sole proprietorship and LLCs with two or more leaders are taxed as a partnership.
- Liability protection for the owner(s) against personal asset seizure for business debts.
- The simplicity of the entity allows for flexibility and growth without third parties or government entities dictating actions.
The disadvantages of becoming an LLC include:
- The business does not exist in perpetuity like a corporation and may be dissolved if something happens to the owner.
- LLCs usually don’t become publicly traded companies, so venture capitalists tend to invest in corporations over LLCs.
[Read more: Tax Impact on LLCs, Partnerships and S Corporations]
S corp vs. LLC: Which is right for you?
Your specific business, financial, and lifestyle goals can help determine whether an S corp or an LLC is the right choice for you. Here are some key factors to consider.
- Owner employment: Both options enable owners to be hands-off, but S corps allow owners to take a salary as an employee while LLCs encourage owners to participate in the management of the organization.
- Ownership structure: S corps require owners to be individuals or certain types of trusts, with fewer than 100 owners — all of which need to be U.S. citizens or a U.S.-based trust. LLCs can have as many owners, or “members,” as they want or need with no classification or nationality requirements.
- Management structure: S corps choose a board of directors that elects officers to run day-to-day operations while LLCs rely on managers to run the company. LLC managers can appoint officers if needed.
- Stock and shareholders: S corps can issue common stock to shareholders while an LLC has no stock or shareholders.
- Taxes: As an LLC can be taxed differently depending on the nature of the incorporation, there are a number of tax factors to consider. Generally speaking, however, LLCs avoid double taxation because all company income is passed through to the tax returns of the individual owners. Similarly, S corps are not subject to corporate income tax and allow for the pass-through of business income and losses to shareholders' personal tax returns.
- Cost: Costs vary widely depending on the state of work and residence and whether a business owner hires an attorney, but incorporating with an S corp tax classification can cost between $100 to $250 dollars. Registering as an LLC can cost anywhere from $50 to $500.
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