Choosing the correct legal structure is one of the most critical early decisions owners must make when starting a new business. Your options will impact liability protection, administrative requirements, taxation levels, and more.
Limited liability companies (LLCs) and S corporations are two of the most popular entities for small business owners because of their liability shields and pass-through tax treatment.
But how do you pick an LLC vs S corporation for your company? Here's an in-depth comparison of the key differences, advantages, drawbacks, and factors to consider when deciding between these structures.
LLC Overview
An LLC is a legal structure registered as its entity. It helps shield owners' assets from business liabilities and debts. LLCs have no limit on the number or type of owners they can have. Day-to-day management tends to be more flexible than other structures. Rather than income taxes, an LLC's profits and losses pass through to owners' tax returns.
The Pros of an LLC
Because it is registered as a separate legal entity from its owners, an LLC offers liability protection by keeping owners' assets distinct in case of a lawsuit or business debt. LLCs also involve less paperwork and administrative red tape than other more complex structures.
For example, they don't have to hold formal shareholder meetings, appoint corporate officers, or complete annual compliance reports in each state where they have business.
LLCs allow for customized management flexibility and ownership equity division. You can divide profits unevenly, issue ownership interest in varying amounts, and create personalized roles and responsibilities for each owner.
This appeal to co-owned businesses with directional Partner distribution flexibility makes LLCs attractive for businesses focused on equity-based funding instead of offering shares to investors.
Registering as an official LLC also immediately builds credibility with customers, lenders, and suppliers. The formal business structure signals that owners are committed to and serious about building a company.
The Cons of an LLC
LLCs also have a few drawbacks to consider. All income earned is subject to self-employment tax of 15.3% rather than alternative corporate tax rates, which can significantly reduce profits.
For businesses anticipating high earnings, the higher taxes may make an LLC less appealing financially.
Also, while LLC ownership can be customized between partners, current IRS rules stipulate that at least one partner must fully materially participate in company operations. Limits on loss deductions against passive income can also come into play here on taxes.
Since LLCs don't issue official stock shares, attracting angel investors or venture capital investment can take more work. The options to divide and distribute profits don't always align with equity investor interests.
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S Corporation Overview
An S corporation is a standard corporation that qualifies for pass-through tax treatment under IRS rules. Like an LLC, it is a formal legal entity separate from its owners.
To become an S corporation, articles of incorporation must be filed with the state, and an S corporation IRS election must be filed.
Owners, known as shareholders in a corporation, enjoy limited liability protection just like in an LLC. Profits and losses also pass through to owners' tax returns in an S-corp structure. However, stricter ownership rules apply to S-corps than to the flexibility that LLCs offer.
Top Benefits of S Corporations
Significant tax savings are among the primary financial incentives for profitable businesses to choose an S Corp. Rather than standard corporate income taxes, income passes through to shareholders' returns, like an LLC.
However, owners only pay self-employment taxes on "reasonable salaries" versus the business's earnings. This can mean thousands in FICA and Medicare tax savings annually for owners actively working in their companies.
S corps also allows owners to deduct health, dental, and vision insurance premiums from their taxes. They can also fully utilize 401k retirement savings accounts. These attractive fringe benefits options aren't available with an LLC structure.
From a professional credibility standpoint with banks, partners, and customers, registering as a corporation signals that a business takes operations and compliance seriously. The corporate structure also represents proven longevity.
Potential Downsides of S Corps
If profits are lower or owners don't directly work in the business, the appeal of an S Corp diminishes quickly. The administrative paperwork and annual filing requirements also add costs and complexity compared to an LLC. Corporations must pay formation, annual reports, and franchise fees at the state level.
Owners must hold shareholder and board of director meetings, keep detailed meeting minutes, and adhere to other formalities LLCs don't deal with.
Corporations also face strict ownership rules. An S corp can only have one class of stock and up to 100 shareholders who are U.S. citizens.
Ownership percentage also dictates income distributions rather than customizable partnership agreements with LLCs. S corps will offer more flexibility for co-owned businesses with plans to scale or attract wide-ranging investors.
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Key Differences Impacting Choice Between LLC vs. S Corporation
Taxation Comparison
The IRS automatically taxes S-corporations at the corporate rate. Electing S-corp pass-through treatment requires filing IRS Form 2553. Only income distributed as reasonable salaries is subject to the 15.3% self-employment tax.
LLCs don't get this tax break. All profits are subject to self-employment taxes. However, LLC taxes can be more straightforward to calculate.
Operational Simplicity
LLCs involve significantly less administrative paperwork, compliance requirements, and formal processes.
S corps face state reporting requirements, board and shareholder meetings, resolutions, officer and director appointments, and detailed record keeping. These time-consuming tasks add operational costs and complexity.
LLCs offer greater flexibility and require less regulatory oversight.
Ownership Structure Rules
S corps limit ownership to one class of stock and 100 shareholders who must be U.S. citizens. Only percentage shares of ownership can be distributed. LLCs have no ownership limits or requirements.
You can divide profits, ownership equity, and management authority between partners in customized, flexible ways.
Liability Protection Differences
S corps and LLCs provide strong liability shields if the formation and operational requirements are met. Personal assets stay protected from business lawsuits and debts.
However, S corps involve more compliance complexities that could put protections at risk if administrative rules aren't followed. LLC liability shields involve less risk.
For most small businesses, though, protections are similar.
Deciding Between an LLC & S Corporation
Choosing between an LLC and an S Corp involves weighing priorities like tax implications, operational bandwidth, ownership structure, liability protection levels, and professional credibility once current finances and multi-year goals are reviewed.
Bringing legal, tax, and accounting advisors to this analysis provides an objective perspective based on decades of structuring experience across industries.
Here are key factors to guide owners in making the LLC vs S corp decision:
Weigh tax savings – Are current or short-term profits over $50k? S Corp rewards can be worth admin time
Will outside investors ever be brought on board? S corps are better for comprehensive capital raising
How many business partners now and in the future? LLC flexibility offers customization.
What fringe benefit abilities appeal most? S corps maximize tax-free options
Can administrative requirements be managed? LLCs involve fewer compliance rules.
Do future exit, growth, or leadership transition plans require flexibility?
By objectively projecting finances, weighing priorities in these critical areas, and determining fit with long-term visions for the business, owners can make an informed LLC vs. S Corp choice best suited for their goals and situations.
Next Steps: No Matter Which Structure You Choose
Even once an LLC or S Corp is registered, owners need to revisit their choice as revenues, staff size, business credit needs, number of locations, and operations evolve over the years.
For example, an LLC can eventually shift to an S or C Corp structure to aid expansion. While changing between entities involves paperwork and legal processes, founders can pivot structures over time if business requirements require it.
Regardless of your current size or future aspirations, forming the appropriate limited liability entity from day one establishes credibility with vendors, lenders, and customers while protecting your assets as you grow.
Weighing out priorities, running projections, and crafting multi-year goals can help immensely determine whether an LLC or S Corp is the best foundational choice as you start building your empire.
Additional Resources
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