Editorial · November 16, 2015
LLC vs S Corporation: How Small Owners Compare
LLC vs S corporation is not always an either-or choice. An LLC is a business form created under state law. An S corporation is a corporation that has made a federal tax election, and an LLC can make that same election.
Both can pass business profit through to the owners' personal tax returns, and both can limit the owners' personal liability. They differ in how owners pay Social Security and Medicare taxes, how much paperwork each needs, and who may own the company. This is general information only. For your own entity choice, ask a CPA or a business attorney.
What each one is
An LLC is a business structure allowed by state statute. Its owners are called members. For income tax, the IRS treats a one-member LLC by default as part of its owner's tax return, and an LLC with two or more members as a partnership. Either kind can elect to be taxed as a corporation instead.
The SBA says an S corporation starts as a corporation chartered by a state. It then elects S status on Form 2553, which all of its shareholders must sign. Its income, losses, deductions and credits pass through to the shareholders, who report the income and losses on their personal returns. The IRS says this lets S corporations avoid double taxation of corporate income.
The two overlap. An LLC that wants S status files Form 2553 and does not need a separate corporate election first. The SBA says the LLC stays an LLC from a legal standpoint. For tax purposes it is treated as an S corporation.
Liability protection
On liability, the two are close. The SBA says LLC members are protected from personal liability for the LLC's decisions or actions. If the LLC owes debts or gets sued, members' personal assets are usually exempt. The SBA says an S corporation is a separate entity under the law, which limits its owners' financial liability.
The SBA also warns that the shield has limits. LLC members are not necessarily protected from wrongful acts, including those committed by their employees. An S corporation does not necessarily shield you from every lawsuit, such as an employee's claim after a workplace incident. Each state may use different rules for LLCs, so check with your state.
How the taxes differ
For federal income tax, the two usually look alike. The SBA says an LLC is not a separate taxpayer, so the business itself is not taxed. The IRS says an S corporation is generally not subject to any income tax of its own.
One gap is self-employment tax, the Social Security and Medicare tax mainly for people who work for themselves. The IRS says an individual who owns a one-member LLC taxed the default way is not its employee. Instead, the owner pays self-employment tax on the LLC's net earnings. The SBA says LLC members are considered self-employed. A working owner of an S corporation is paid a wage instead. The SBA says employment tax applies only to that wage. The rest of the profit can come out as a distribution.
Say a one-owner business earns $80,000 before paying its owner. As an LLC taxed the default way, self-employment tax applies to those earnings. As an S corporation, the owner might take $50,000 as a wage, which carries employment tax. The other $30,000 could be a distribution. This is our own simple example, not IRS guidance.
The catch is reasonable pay. The IRS says an S corporation must pay a shareholder-employee reasonable compensation for services before it makes non-wage distributions. The IRS can reclassify other payments to that owner as wages, which are subject to employment taxes. Factors the IRS lists include duties, time and effort, training and experience, and what comparable businesses pay for similar services.
State rules differ. The SBA says some states tax LLC income, and some do not recognize the S election.
Who can own it
An S corporation must be a domestic corporation with no more than 100 shareholders. For that count, spouses are treated as one shareholder. Shareholders may be individuals, estates, certain trusts and certain exempt organizations. They may not be partnerships, corporations or nonresident aliens. The company can have only one class of stock. In general, that means every share has the same rights to distributions and liquidation proceeds.
An LLC faces far fewer limits. The IRS says there is no maximum number of members. Most states do not restrict ownership, so members can be individuals, corporations, other LLCs or foreign entities. The SBA says LLC members can share profits as they see fit. An LLC that elects S status has to pass the same tests as any other S corporation.
Paperwork and timing
An LLC is the lighter of the two. The SBA says an LLC has less registration paperwork and smaller start-up costs than an S corporation. You file articles of organization with the state, and there may be a filing fee. Most states do not require an operating agreement, though the SBA recommends one for an LLC with multiple members. Taxed the default way, a one-member LLC with an individual owner reports its income on Form 1040, for example on Schedule C. An LLC with multiple members generally files Form 1065.
An S corporation takes more work. The SBA lists scheduled director and shareholder meetings, minutes, bylaws, stock transfers and records. For tax, it files Form 1120S and gives each shareholder a Schedule K-1. If it pays wages, it also files employment tax returns, such as Forms 941 and 940.
Form 2553 has two filing windows. The IRS says you can file at any time during the tax year before S status starts. You can also file up to two months and 15 days after the first day of the tax year S status starts. In the IRS example, an existing calendar-year corporation has until March 15 of the year S status starts.
Talk to a tax professional and a business lawyer before you file anything.