Most US entrepreneurs and small business owners set up an LLC when they want to “make it legal”. LLCs are easy and comparably cheap to set up and operate. They can also be tax efficient, especially for entrepreneurs abroad. But they are not the only good choice for a small business structure.
S Corporations have similarities with LLCs, but also some distinct characteristics, that may be more advantageous for a business.
Let’s compare LLC and S Corp.
What LLC and S Corp have in common
- Limited liability protection. The personal assets of the owner(s) are protected against debts, losses, and any court rulings against the business.
- Separate legal entity. Filing on state level creates a legal entity that is separate from the owner(s). The entity has to comply with state-mandated formalities, such as filing annual reports and paying the fees.
- Pass through taxation. LLCs and S Corps don’t pay income taxes at the business level. Instead business profit or loss is passed through to the owners’ personal tax returns. Any tax is reported and paid at the individual level.
Advantages of an LLC over S Corp
- No restriction of ownership, i.e. members of LLCs can be Non-U.S. citizen/residents.
- LLCs can be owned by a corporation and certain types of trusts, while S corporations cannot.
- LLCs can have subsidiaries without restriction.
- Less paperwork. Internal formalities are recommended but not required for LLCs (although this can be a disadvantage as it often leads to a lack of documentation of agreements and business decisions).
- Flexibility in management.
- Less complicated taxes. An LLC is either recognized on the Schedule C of an individual return or as a partnership if multiple partners, whereas an S Corp always must file an 1120S. An individual owner of an LLC does not pay unemployment or disability taxes, but that also means that the owner is not entitled to state unemployment or disability benefits. They are also not required to take a minimum salary and deal with payroll taxes. (More about that in a later post.)
Advantages of an S Corporation over LLC
- S Corps can sell stock, which can be traded freely, as long as IRS requirements are met. An LLC by comparison can only sell interest in the company.
- Appeal to investors. Not only due to its ability to issue stock, but also because S Corps have a more rigid management structure and more extensive reporting requirements. Those required formalities include adopting bylaws, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.
- Reduced self-employment tax. An S Corp can pay a reasonable salary to its working owner(s), which is a deductible business expense. This will limit the amount of self-employment taxes (Social Security and Medicare taxes) that is due, as it is only applicable to the amount of salary taken. The remaining net income of the S Corp is considered a distribution and not subject to self-employment tax. This is the main advantage why people choose an S Corp as business structure.
LLC vs S Corp – Which structure is right for your business?
As you can see, there are various points to consider when selecting a business structure. Many entrepreneurs start out with an LLC and switch later to an S Corp. Read more here about when you should to convert from LLC to S Corp.
We offer services to set up a tax-efficient business structure and prepare business tax filings. Learn more about our services and pricing here. If you need help to determine the best legal structure for your small business, please set up a free consultation.
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