LLCs and S-Corporations are often talked about together, but they are not an either-or choice. There are similarities and differences. A limited liability company (LLC) and a corporation are both legal business structures that are commonly used by small business owners. An “S-Corp”, however, is a tax classification. Historically, a corporation would be the entity of choice if you wanted to be treated for tax purposes as an S-Corp. Now, the IRS will allow you to elect to have both types of entities taxed as an S-Corp with the proper document filing. Many companies choose this option for tax advantages, but it’s important to know when and how these advantages apply.
Differences Between LLCs and Corporations
Both these business types will require you to file business formation documents with the state. Both protect company owners from personal liability for business obligations. In general, corporations have a more standardized and rigid operating structure and more reporting and recordkeeping requirements than LLCs. LLC owners have greater flexibility in how they run their business. Taxwise, LLCs have more options than corporations. LLCs aren’t tied to one particular tax classification and can be taxed as sole proprietorships, partnerships, C corporations or S corporations.
An LLC’s owners are called “members.” Each member owns a percentage, or “membership interest” in the business. Individuals, corporations, other LLCs, and foreign individuals can own membership interests in LLCs.
The ownership of an LLC is outlined in the business’ operating agreement—other details include the percentage each member owns, how the business is run, and how the company will deal with a new or departing member. Without an operating agreement, the LLC operates according to state law. In some states, the LLC needs to be dissolved if a member leaves, with the remaining owners forming a new LLC if they wish.
A corporation is different from an LLC in that corporate owners are known as “shareholders” whose ownership percentages reflect the number of shares of company stock they own. If there are no written agreements that say otherwise, it’s easier for a corporation to authorize additional shares, or for shareholders to transfer their shares to someone else.
LLCs can be managed by their members (owners), or they can be managed by one or more managers, with the members acting more like passive investors. The people running an LLC–whether members or managers– don’t have to adhere to traditional roles or titles like CEO or Vice President, but can create a management structure that works for their business needs.
In contrast, corporations operate with a much stricter management structure, with a board of directors overseeing the business and officers who manage daily operations. Shareholders must meet at least annually. Paperwork and record-keeping for shareholder and director meetings is extremely important with corporations.
Reporting of Profit and Loss/Income Taxation
There are two ways a corporation can be taxed. By default, corporations are C corporations. They file a corporate tax return and pay corporate taxes. If the shareholders take distributions from the company, they’ll report those distributions on their personal tax returns (along with any company salary they receive) and pay personal income taxes on them.
Some corporations can avoid this double taxation of distributions by electing to be taxed as an S Corp. S Corps don’t pay corporate income tax. Instead, the company’s profits pass through to the shareholders’ personal returns and each shareholder pays individual taxes on their portion. To be eligible for S Corp taxation, a corporation must have 100 or fewer shareholders who must all be legal residents or citizens of the Unites States (stock cannot be owned by an LLC, C-Corp or Partnership) and have only one type of stock (no preferred stock).
LLCs, on the other hand, don’t have an IRS tax classification of their own. Single-member LLCs are automatically taxed like sole proprietorships and multi-member LLCs are automatically taxed like partnerships. In either case, however, the company profits pass through to the members, and the members pay income taxes on their share. LLCs can elect to be taxed as an S-Corp (if all of the members meet the requirements mentioned above to be an S-Corp).
The minimization of Self-Employment Tax is generally the reason that many small business owners make an S-Corp election when they incorporate or decide to have their LLC treated as an S-Corp for tax purposes.
S Corps can pay out a portion of the owners’ income as salary. The salary is taxed as employment income, which is subject to FICA payroll taxes (15.3% of your gross wages). Your S Corp pays half of this amount (7.65%) as employer taxes and gets to write them off as a business expense. You pay the other half (7.65%), and these taxes are withheld from your paycheck. If 15.3% sounds familiar, it’s because the self-employment tax you pay as a sole proprietor is 15.3% of your taxable earnings. The S Corp advantage is that you only pay FICA payroll tax on your employment wages. The remaining profits from your S Corp are not subject to self-employment tax or FICA payroll taxes. Those profits are only subject to income tax.
Here’s an example: If you make $100,000 in earnings from your S Corp, you can have that income paid out as $50,000 in salary and $50,000 in profit. You’ll pay FICA payroll taxes (15.3%; yes the same amount as self-employment tax) on just $50,000 instead of the whole $100,000. The remaining $50,000 of your income is only subject to income tax.
Why not make my salary $1.00? Another crucial factor is what the IRS calls a “reasonable salary.” That $50,000 we mentioned in our example above assumes that $50,000 is a reasonable wage to pay you for your hours worked and duties performed. There’s no one-size-fits-all guidance for calculating your S Corp salary, and you’ll have to determine what is reasonable for your situation.
Both corporations and LLCs are limited liability entities. This means the owners aren’t personally liable for business debts or lawsuits against the business. Business owners do, however, remain liable for their own negligence and for any obligations on which they’ve signed a personal guarantee.
To maintain this liability protection, both corporations and LLCs should always keep business and personal finances separate. Owners should sign documents and contracts on behalf of the company, not in their own personal capacity. For corporations, additional documentation needs to be maintained as well. This includes corporate minutes, details on annual shareholder meetings, and information on its board of directors.
Reporting to the State/Registered Agent
LLCs and corporations also need to make required filings and reports to stay in good standing with the state. Both types of businesses must maintain a registered agent and update the agent information on file with the state as necessary. Most states require LLCs and corporations to file an annual report or franchise tax reports to maintain an active status. The annual report form will ask you to ensure you have updated information pertaining to your business and you will have to pay a filing fee. Some states require this to be completed every other year.
With both entities, you will need to designate a registered agent with the state. You can be the registered agent for your company, or you can designate our office as your registered agent. There are many reasons to elect our office to act as your registered agent and those are outlines on a separate document explaining what services we provide as your registered agent.
Before choosing an entity or a tax classification, we suggest at least a minimal consultation with your CPA. Your CPA may know facts or circumstances about your situation that you might not be aware of. If you have a CPA, please let us know. If you need a CPA, we can give you a referral.