Business leaders face a variety of challenges on their journey to becoming owners of their own companies. Aside from generating financial support and coming up with a lucrative business idea, they also need to choose the correct business model for forming their company.
Even if you have the means and the idea, choosing the wrong kind of business model can lead to poor outcomes. Market research could help you to find an adequate business model for that moment in time, but your long term business success ultimately depends on the choices you make.
Your business entity depends on the corporate structure you choose because it determines your course of action regarding tax payment, personal liability, money management, paperwork, and more. While there are many options available, two of them stand out – LLC and S corp.
Here, we’ll explain both business structures and examine their differences and similarities to help you to make an informed decision.
Defining an LLC
LLC stands for limited liability company. It’s one of the most popular business models in the U.S. An LLC is a business entity that can have one or more managers, members, or owners.
A limited liability company is a flexible and convenient business structure. It combines the benefits and features of a corporation and partnership.
Company owners are exposed to limited liability if the company fails due to legal claims and debts. Depending on the state, an LLC business structure can offer beneficial taxation practices that can help you to save money long-term. Your state taxes the LLC revenues as your personal income.
An LLC requires an operating agreement to function, and it has two choices of business structures:
- Ownership – this model has one person as a business owner, or it can refer to a multi-member structure; or
- Management – this business structure requires a manager to run the business operations. The management model is also called a manager-managed LLC. There’s also a member-managed LLC where one or several members are company managers.
The most important thing about an LLC business structure is limited liability. Owners, managers, and members receive additional legal protection from personal and corporate liability.
Limited liability provides legal protection against creditors. Members and owners aren’t subject to claims against the LLC, nor are they responsible for any debt.
There are eight types of LLCs:
An LLC business structure provides legal protection for securing your assets, allowing you to save on taxes. Forming an LLC is easy and it also allows you to choose how you want to pay your business-related taxes. You can hire professional services to handle the LLC formation on your behalf.
Defining an S Corporation
S corps aren’t business entities but tax classifications. They are subject to taxation under Subchapter S of the Internal Revenue Code, but unlike C corps, S corps and LLCs are subject to only one taxation layer. In other words, this business structure could help you to save money on taxes.
Although forming an S corp is similar to the same process as with an LLC, this business structure requires filing an S Election Form 2553 with the Internal Revenue Service (IRS). This form defines your business entity as legal in the eyes of the state.
An S corp owner pays business-related income tax through their personal tax returns. Forming an S corp is also subject to various IRS eligibility requirements:
- A company must be a U.S. business;
- There can’t be more than 100 owners or shareholders;
- S corp owners can be estates, trusts, and individuals;
- Non-residents, partnerships, and corporations can’t be S corp owners; and
- S corps are subject to one class of stock.
Since S corp has one taxation layer, you can choose how you want to pay your corporate taxes:
- At the shareholder level; or
- At the corporate level.
An S corp allows business owners to leverage the tax advantages and avoid bothering with the state laws and regulations regarding corporate formalities.
Forming an S corp is an excellent option for business owners who generate enough revenue to change their tax structure and classification.
Main differences
Let’s compare LLCs and S corps to see how they differ.
Ownership
LLCs are not subject to any IRS restrictions regarding ownership. However, S corps must follow the IRS rules that don’t apply to LLCs.
These rules include the following:
- S corps can’t have more than 100 owners (shareholders), while LLCs can have unlimited numbers of owners, managers, or members;
- S corps must be U.S. businesses, while LLCs can have non-U.S. residents as members;
- Trusts, partnerships, and corporations can own LLCs but not S corps;
- No restrictions are preventing LLCs from having subsidiaries; and
- LLCs aren’t subject to restrictions regarding issuing classes of stock with different financial rights, while S corps don’t enjoy the same privilege.
As long as S corp owners meet the IRS ownership rules, they are free to transfer S corp stock. Transferring LLC ownership without members’ approval isn’t possible.
Management structure
While only owners (shareholders) can manage S corps, LLCs are more flexible and can have managers or members manage the operation. They can either be sole proprietorships or partnerships.
S corps, on the other hand, have officers and directors. While directors manage decision-making and corporate affairs, they don’t manage daily business operations – they have officers for that kind of work.
Formation requirements
S corps and LLCs are subject to different formation requirements.
S corp formation requirements include:
- No foreign investors;
- Business must be a domestic corporation;
- An S corp can’t have more than 100 owners (shareholders); and
- It can have only one class of stock.
Electing S corporation status also requires a business owner to file an IRS Form 2553 with the IRS.
Taxation
An S corp business structure allows owners to avoid double taxation. They can choose to pay corporate taxes at the shareholder or corporate level and are subject to federal tax law, while LLCs follow state law.
LLC owners pay self-employment taxes, such as social security and medicare taxes, directly to the IRS. All LLC revenues are subject to taxation, while an S corp has a different taxation method.
Shareholders earn salaries, and the company handles their payroll taxes. Owners can decide how they want to deduct the payroll taxes from the corporate taxable income. Typically, they sign off payroll taxes as a corporate expense.
Payroll
S corp shareholders earn a monthly salary that counts as taxable personal income. They pay medicare and social security taxes, while LLC members earn income based on self-employment. They must pay self-employment income taxes.
Business operations
S corps are prone to rigid structural and formal operational requirements, including restrictions on issuing stock shares, keeping meetings, and adopting corporate bylaws. They either use cash basis or accrual accounting services.
LLCs, on the other hand, aren’t subject to the same corporate requirements as S corps. They can avoid corporate bylaws by using LLC operating agreements that provide LLCs more flexibility regarding business operations.
How are they similar?
Even though there are differences between LLCs and S corps, there are also similarities.
Compliance requirements
LLCs and S corps must follow LLC statutes and state corporation regulations. Both business structures must notify the respective states of any changes, such as:
- Change of company name;
- Change of registered agent;
- Change of business entity type; and
- Change of state of business (if it’s outside of the formation state).
Both models must pay annual fees, file annual reports, and appoint a registered agent.
Pass-through tax entities
LLCs and S corps are both pass-through tax entities. However, LLC owners have the option to opt out of pass-through taxation.
Pass-through taxation refers to paying business-related (no income) taxes at the corporate level.
This taxation model allows business owners to report and pay taxes at the individual level by passing through to their personal tax returns.
Limited liability protection
S corp and LLC owners aren’t personally liable for corporate liabilities and debts. Instead, their business entities take responsibility for legal claims and debt.
Which one to choose
LLCs and S corps offer limited liability protection and pass-through taxation. An LLC is a more suitable option for partnerships and single-owner businesses looking for more business management flexibility.
An S corp might be more appropriate for companies with multiple members or owners. Whether you want to form an LLC or an S corp, you should hire a professional incorporating service provider to simplify the process.
Conclusion
LLCs are more affordable and easier to form. An LLC requires simple management and is subject to less rigid reporting requirements and operational regulations, while S corps are a preferable option for business owners looking for outside financing.
Although the S corp business format requires a more complex approach, this business format shares a few similarities with LLCs. Both business formats offer limited liability protection, double taxation evasion, and flexibility in management.