As I have touched on before, choosing an entity can be a tough decision for a business owner. While many business owners prefer an LLC’s simplicity, some may wonder if there’s a way to get the benefits of both a corporation and an LLC.
Enter the S corp vs. LLC debate.
You may have heard of an S corporation (or “S Corp”) before. S corps offer some of the same benefits as an LLC, such as limited liability protection and pass-through taxation. However, there are also some important differences.
In this article, we’ll take a closer look at S corps and LLCs and discuss the pros and cons of each entity. As always, this article is only meant to help you understand these concepts. You will want to talk to a professional if you need legal or tax advice.
What is an LLC?
An LLC is a type of business entity created under state law. The key benefit of an LLC is that it creates a liability shield for its owners. This is because an LLC is treated as a separate entity from its owners (“members”). This is called limited liability.
Limited Liability
Often, when a person opens a business, they do so as a sole proprietor or a partnership. You have likely heard these terms before, but let’s examine them a little closer.
Sole Proprietor: a sole proprietor owns a business personally (not through an entity or partnership). A sole proprietor is personally responsible for the debts and liabilities of their business, even if they are operating under an assumed name or d/b/a.
Partnership: when two or more people or entities own a business together, this is called a partnership. Like a sole proprietorship, the partners of a business are personally liable for the debts and liabilities of the business. Note that there are other forms of partnerships, such as Limited Partnerships and Limited Liability Partnerships, where there may be some liability protection. For most partnerships (called “general partnerships”), the partners are liable for debts and liabilities.
As I mentioned, the main benefit of an LLC is that it limits liability for the company’s owners. Unlike sole proprietorships and general partnerships, the members of an LLC are not liable for the debts and liabilities of the company (outside of some exceptions). That means if the company gets sued, in most cases, a member’s personal assets are safe from a judgment against the company.
Taxation
By default, LLCs are treated as “pass-through” entities for tax purposes. So the company itself does not file a tax return. Instead, the taxes pass through directly to the members. How this happens depends on whether the company is a single or multi-member LLC.
Single Member LLC
A single-member LLC is treated as a “disregarded entity” by the IRS. Accordingly, income taxes and reporting are made directly by the owner of a single-member LLC. The owner will pay taxes as if the income and losses of the company were their own. In many cases, an LLC owned by a married couple will also be treated as a single-member LLC.
Multi-Member LLC
If there are two or more members (who are not married to each other), then the LLC will be treated as a partnership for tax purposes. Multi-member LLCs will need to file an information report with the IRS and issue K-1 forms for the members. Like a single-member LLC, the income and losses of the LLC are passed through to the members. The share each member is responsible for should be outlined in the LLC’s company agreement or other governing documents.
Self Employment Taxes
LLC members actively involved in the company’s management will likely need to pay self-employment taxes. For 2023, the self-employment tax rate is 15.3% (which covers Medicare and Social Security taxes). Social Security and Medicare taxes normally withheld from employee wages, so the IRS uses self-employment taxes to ensure that self-employed individuals are also paying into these programs. This can be a big tax hit, which leads many owners to wonder if there is a way to avoid self-employment. For some, this is what draws them towards an S corp.
What is an S Corp?
Despite what many people think, an S corp is not a type of entity but rather an election that a business can make to be taxed as a pass-through entity. Like an LLC, this means that the profits and losses of the business are passed through to the shareholders, who are then responsible for paying taxes on their share of the profits. S corps offer many of the same benefits as regular corporations, such as limited liability protection and centralized management. However, they also offer the potential tax advantages of an LLC, including the ability to avoid double taxation.
Self-Employment Taxes for S Corps
S corps, like LLCs, are subject to pass-through taxation. Unlike an LLC, however, the S corp owners may be able to reduce their self-employment taxes. When a company elects S corporation status, the owner can pay themself a reasonable salary from the company. The owner can also choose to take a distribution of the additional income of the company that wasn’t paid out in the salary. However, the owner will still need to pay self-employment taxes on the salary portion of the income. The distribution portion should only require them to pay ordinary income taxes.
The key here is that the salary must be reasonable. This means the salary the owner takes should be commensurate with the services provided to the company and should be comparable to what other similar companies in the same industry pay for similar services. Taking a low salary could subject the owner to an audit and penalties.
What is the Difference Between an S Corp and an LLC?
One key difference between an LLC and an S corp is how self-employment taxes are handled. Another important difference is that an S corp has very strict ownership requirements. We’ll go over the requirements in greater detail below:
- The S corp must be a domestic entity.
- The owners must be individuals, certain trusts, or estates. Partnerships and corporations cannot be owners.
- The corporation can have no more than 100 shareholders or members.
- The corporation can only have one class of stock or membership.
- The owners must be U.S. citizens or legal residents.
Many owners choose not to elect S corp status because of these requirements. LLC members who meet the requirements may wonder if they can convert to an S corp.
Can an LLC be an S Corp?
Yes! If an LLC meets the above requirements, it can elect to be taxed as an S corporation. This does not convert the LLC to a corporation; it only changes how the company is taxed. The LLC must first elect to be taxed as a corporation to make the election. It can then make the S corp election as well. Keep in mind, however, that an LLC still must meet the S corp ownership requirements.
What is the Downside of an S Corp Election?
Making an S corp election can have some complications. As discussed earlier, an owner may come under scrutiny from the IRS if their claimed salary is too low. We also discussed the restrictive ownership requirements for S corps. There is one more “BIG” issue to be aware of with S corps.
Built-In Gains Tax
The built-in gains tax (“BIG tax”) is a special tax that can apply to S corporations, formerly C corporations. The BIG tax is imposed on the sale of assets that were appreciated when the S election was made. The amount of the BIG tax is the difference between the asset’s fair market value on the date of the S election and the asset’s basis. The BIG tax is imposed at the corporate tax rate of 21%. The tax may be avoided if S corp has been in existence for at least five years before the sale of the asset.
The BIG tax can be a big issue for some S corp owners. It’s important that businesses understand the potential BIG tax impact before they make an S corp election.
S Corp vs. LLC: And the Winner Is…
It depends! Okay, I know that answer sounds like a cop-out, but it’s true. It’s hard to beat the simplicity and ease of an LLC. Where LLCs fall behind S corps, however, are self-employment taxes. An S corp may be a good option if these taxes are a major sticking point. For many businesses, however, the potential issues related to S corps are enough to scare them away.
As always, please remember this is not legal advice. If you are mulling these options over, please talk to an attorney and a CPA to make an informed decision about which entity is right for you.