Limited liability companies (LLCs) and S Corporations are business structures that provide liability protection for business owners and allow for pass-through tax treatment. While they have those things (and some others) in common, they differ in several ways, too. If you’re starting a business or considering changing a sole proprietorship or general partnership to an S Corporation or LLC, it’s critical to understand the similarities and differences. Every business and business owner’s needs are unique in some respects, so I encourage entrepreneurs to do research on their own and enlist the expertise of an attorney and tax advisor when deciding how to structure their company.
To get you started in your due diligence efforts, I’ll share some of the basic considerations when evaluating the pros and cons of the LLC and S Corp.
Overview of the LLC and S Corporation
A limited liability company is a statutory business entity that one or more business owners (called members) may form. Each state requires the filing of registration paperwork (usually called “Articles of Organization”) with the secretary of state (or comparable agency) office to establish an LLC.
S Corporation status is a tax election option that eligible LLCs (or corporations) may choose. In the case of an LLC, an S Corp election may be applied for when forming the limited liability company or at a later time by submitting the appropriate form with the IRS. For the purposes of business compliance, an S Corp must meet whatever requirements the underlying business entity must fulfill. In other words, an LLC that elects to be treated as an S Corp must follow its state’s rules for LLC business compliance.
Considerations When Choosing Between an S Corp and a Limited Liability Company
1. Ownership Eligibility
A limited liability company can have one or more owners (members), including individuals, other LLCs, corporations, or foreign entities. Generally, states don’t restrict how many members an LLC may have. However, some states prohibit certain types of businesses (such as those in the insurance and banking industries) from forming an LLC. Also, some states do not allow licensed professionals (such as doctors, lawyers, accountants, and architects) from operating as an LLC. As an alternative for those types of professionals, states may allow the formation of an entity called a professional limited liability company (PLLC).
It’s crucial for an LLC to document its members’ percentage of ownership, roles, and responsibilities in a written LLC operating agreement.
The eligibility requirements to become an S Corporation shareholder are more restrictive than those for an LLC. To elect tax treatment as an S Corp, an LLC must be a domestic company with owners who are individuals, certain trusts, or estates. Partnerships, corporations, and non-resident aliens may not be S Corp shareholders. Other restrictions on S Corps are a limit of only up to 100 shareholders and the stipulation that they issue only one class of stock.
2. Liability Protection
Both the LLC and S Corp protect business owners’ personal assets. They limit personal liability for the business’s debts or legal action taken against the company. As you may imagine, this provides some peace of mind as an individual’s home, cars, bank accounts, retirement savings, and investments are protected from the liabilities and risks of the business.
However, a court might rule that an LLC’s members or S Corp shareholders are personally responsible for debts and legal issues of the business if they acted fraudulently, personally guaranteed business loans, or were negligent or reckless in some way that caused harm. Another way the “corporate veil” of liability protection might be pierced is if the LLC doesn’t fulfill its business compliance obligations.
3. Business Owner Income
A disregarded entity LLC’s owners cannot be considered employees of their company. Therefore, they do not get compensated through company wages or salaries. To get paid by the business, LLC members take money out of their share of its profits.
- Single-Member LLC – The LLC owner withdraws money by taking an “owner’s draw.” Typically, this happens via the LLC owner writing themselves a check from the business bank account or otherwise transferring funds from the business to their personal bank account.
- Multi-Member LLC – When a member needs money, they take a draw from the LLC, which is accounted for in that individual’s capital account (a log of the member’s membership shares of the LLC and their financial activities). Usually, draws are executed via business checks written out to the members. Most states allow LLCs flexibility in dividing profits among their owners (e.g., according to ownership percentage or some other criteria).
In some scenarios, LLC members may have alternate ways of getting paid for services they provide to the company. A knowledgeable tax advisor or accountant can shed some light on what options exist.
An S Corporation’s owners (called “shareholders”) who do substantial work for the S Corp are considered employees and must be on the company payroll. They then receive compensation from the S Corp through wages or salaries. The company must complete payroll registration with the federal and state governments. It will be responsible for withholding and remitting FICA (income taxes, Social Security and Medicare taxes), FUTA (unemployment taxes), and possibly other taxes from those wages and salaries.
S Corp shareholders may also receive income via distributions made when the company has profits to divide amongst its owners. Those distributions must be paid to shareholders in proportion to their share of ownership.
4. Pass-Through Taxation Differences
By default, no matter in which state an LLC is registered, the entity is considered by the IRS to be the same tax-paying entity as its owners. As a “disregarded entity,” the LLC has what’s called “pass-through tax treatment.” Rather than filing a business tax return and paying corporate taxes, business owners report the LLC’s profit and losses on their personal tax returns and pay tax according to the appropriate individual tax rates. LLC members are responsible for income tax and self-employment taxes (Social Security and Medicare) on their company profits.
With S Corp tax treatment, LLC members still have pass-through taxation. However, the owners only pay Social Security and Medicare taxes on their wages and salaries from the business. Income taken as distributions is not subject to self-employment taxes.
A word of caution! Some S Corporation owners run into trouble because they try to game the system by paying themselves a meager salary and taking most of their compensation in distributions. Their attempts to minimize the amount of FICA and payroll taxes they must pay rarely go unnoticed by the IRS and Social Security Administration. The agencies watch S Corps closely to look for red flags.
The moral of the story: Research what is a “reasonable salary” for S Corporation owners. The right amount will depend on the industry, the shareholders’ experience and expertise, the scope of everyone’s duties, and other factors.
5. Methods of Raising Capital
Both the LLC and S Corporation allow borrowing money and selling equity to raise capital to start and grow the business. An LLC can sell ownership interests in the company according to the provisions in its LLC operating agreement. An S Corporation may issue shares of stock to raise money – that is, until it reaches its 100 shareholder limit.
6. Ongoing Business Compliance Responsibilities
LLCs, including those electing S Corp status, must fulfill the ongoing LLC business compliance tasks that their states require. These may vary from state to state, but I’ve listed several common requirements below.
- File an Annual Report
- Maintain a registered agent
- File tax returns and pay taxes on time
- Hold an annual meeting and record minutes
7. Duration of the Business Entity
The LLC and S Corporation structures may live on in perpetuity. Unless business owners dissolve the entity (or the state administratively dissolves it), or there’s some provision in the operating agreement that calls for dissolution under specific circumstances, the company can survive even after its original owners are no longer a part of it.
Steps for Forming an LLC
The steps to form an LLC may vary depending on the state and other factors. Here are the tasks that typically must be completed:
- Check to see if the desired business name is available for use.
- Designate a registered agent.
- File Articles of Organization with the state.
- Create and keep an LLC Operating Agreement at the principal place of business.
- Obtain an EIN.
- File an Initial Report (if required).
- Publish notice of the LLC’s formation in a newspaper (if required).
- Apply for any required business licenses and permits.
- Register for payroll taxes.
Steps for Electing S Corp Status
Either when business owners are filing their business registration paperwork to create their LLC or at some point after an LLC is established, the process to choose an S Corp election is very straightforward. Simply file IRS Form 2553 (Election by a Small Business Corporation).
Newly formed LLCs have two months and 15 days (75 days) from their date of formation to file for S Corporation election. Existing LLCs must file Form 2553 no more than two months and 15 days after the beginning of the tax year when the election is to go into effect. If an LLC fails to timely file its IRS form 2553 with the IRS, the S Corporation election will NOT be effective for that tax year. Relief for late election may be available if the LLC can show that the failure to file on time was due to reasonable cause. LLC owners can request a six-month extension to file for S Corporation status by filing IRS Form 7004.
Most statutory laws conform to the IRS requirements and specifications for an S Corporation. However, some states require a separate S Corporation filing at the state level if a business wants to be treated as an S Corporation for state income tax purposes.
When an LLC Might Benefit From Selecting an S Corp Election
S Corporation status may or may not be advantageous for an LLC and its owners. Generally, business owners who want to lower their Social Security and Medicare tax obligations without grappling with the extensive registration and compliance tasks of a C Corporation may find the S Corp election for an underlying LLC attractive. And if LLC members foresee wanting to someday file taxes as a partnership or sole proprietorship, converting from an S Corp to a disregarded entity LLC is easier than changing from C Corporation.
Still, business owners must consider other factors, and determining whether the S Corp route is ultimately best can be confusing. I recommend talking with an attorney and tax advisor to weigh the benefits of the S Corp vs. LLC before deciding.
Can individual LLC members choose different tax treatments?
Yes! Single Member LLC’s are not required to obtain a Federal Tax ID Number. However, if a person decides to convert the LLC to be taxed as an S Corporation, a Federal Tax ID Number should be obtained. Further, to be taxed as an S Corp, an S Corporation election needs to be filed with the IRS via Form 2553.
Do you need an adjusted LLC operating agreement if an LLC files for an S Corporation election?
You would need to revise the tax provision language mentioned in the operating agreement to properly reflect any elections made, such as the S Corporation Election.
Get Help Filing Your Paperwork
When completing business registration and tax forms, it’s important to get them right from the start. Otherwise, it can cost additional fees and delay when a company can begin conducting business. Fortunately, my team at CorpNet takes the guesswork out of preparing and submitting critical business filings. We work with business owners in all 50 states, and we understand the ins and outs of every jurisdiction’s paperwork.
Contact us if you want assurance that your Articles of Organization, Form 2553, and other filings are done accurately and on time. We’re here to help you start your business now and keep it compliant year after year!