What is the difference between an LLC and S Corp?
A Limited Liability Company (LLC) and an S Corp, sometimes called an S Subchapter, are two types of legal entities used to form and operate a business. S Corps and LLCs share many similarities, and both have their advantages and disadvantages for business owners.
Some similarities include:
- Liability protection for owners
- Tax structure and benefits
- Management structure
While differences can be found in these areas:
- Formation, set-up, and maintenance
- Business laws
- Financing
- Length of existence
Read more about LLCs and S Corps, here .
Which is better, S Corp or LLC?
It is difficult to say which business formation is better because choosing which entity to form for your business will depend on your individual business needs.
An S Corp and an LLC offer the same liability protection to the business owner. Both business entities are legally separate from the owner. In the event of a lawsuit or a creditor collection, the owner’s personal assets are protected.
Both S Corps and LLCs are taxed in a similar manner in that they are pass-through entities. Neither business pays corporate taxes and the owner reports earnings and losses on their personal tax return.
An LLC is simpler to set up and less expensive to maintain than an S Corp. LLCs provide more flexibility for owners because they are not subjected to the strict IRS guidelines imposed on S Corps.
If a business is looking to secure outside financing and big investors, an S Corp will be the better option because unlike an LLC, S Corps have shareholders and can issue stock to investors.
Another difference between these two business entities is that an LLC can be dissolved if a member or an owner withdraws from the business. An S Corp tends to have perpetual existence.
While neither entity is necessarily better, a business run by a single owner who wants to maintain full control of their company and have flexibility should choose an LLC. If there are several owners involved in a business and the business will be seeking investors for additional funds, then an S Corp formation would be more beneficial.
For more information about choosing between an LLC and an S Corp, read this article .
How LLCs Work
When an LLC is formed, it becomes its own legal entity separate from the business owner or owners. An LLC must have a registered agent and must file articles of organization or a certificate of formation with the state in which they are doing business.
There are two ways to structure an LLC:
Ownership Structure- In an ownership structure the owner of the LLC is called a “member”. There can a be a single-member LLC in which there is only one owner, or a multi-member LLC in which there are two or more owners who are also referred to as members.
Management Structure- A management structure allows the day-to-day operation of the business to be controlled by managers. In a single member or small multi-member LLC, it is common to have the member act a manager. This is called a member-managed LLC.
How to Form an LLC
Every state has their own laws regulating the formation of LLCs. Usually, an LLC is required to file articles of organization or a certificate of formation with the Secretary of State. This document will require information about the company like:
- The name of the LLC
- The effective date of the formation of the LLC
- The name and address of the registered agent of the LLC
- The company’s principal office
- The business purpose or sometimes called “general character” of the LLC
- Duration of the business
- The name and address of one member of the LLC
- The name and address of each organizer of the LLC
- Some states require a copy of the name registration certificate
- Signature of the authorized representative
It is good business practice for an LLC to have an operating agreement similar to corporate bylaws even though it is not required. This document will lay out how the company will be run.
Read this article to learn more about LLCs.
Pros of an LLC
LLC’s provide business owners with many advantages from daily management to taxes. Below are a few benefits of forming and LLC:
- Limiting Personal Liability for Business Debts: LLCs provide owners with personal protection from liabilities, like debt or lawsuits. In the event of a lawsuit, only business assets are at risk to be claimed as a remedy. An owner’s personal property and assets are protected.
- Ability to Raise Capital from Investors: The owner of an LLC has the option to bring in investors who can contribute additional capital, property, or even services to the business.
- Tax Advantages: An LLC owner does not have to file a separate tax return for the business. LLCs are “pass through entities” because profits and losses from the business pass through the business to the owner’s personal tax return. LLCs with more than one owner also have the option to choose to be taxed as a corporation.
- Flexibility: LLCs offer business owners maximum flexibility. They are not regulated like an S Corp. LLCs can have one or many members, face less reporting obligations, and are easier to form than an S Corp.
Cons of an LLC
Even though the business formation of an LLC provides the owner with great liability protections, there are limits to this protection. An LLC owner will still be personally liable in the following situations:
- A lawsuit for their own negligence, even if the claim is related to the business.
- Losses due to fire, floods, lawsuits, or economic downturn
It is also more difficult for an LLC to secure outside financing. This is because LLCs do not have stock like an S Corp to offer to investors.
LLCs and Taxes
A single-member LLC is usually taxed just like a Sole Proprietorship by what is called “pass-through taxation”. Profits and losses of the business pass through the business and are filed with the owner’s personal tax return.
The LLC owner will report their businesses profits, losses, and deductions to the IRS using a Schedule C form filed with their personal tax return. If there is more than one owner, each owner will file profit and losses with their own personal tax return.
LLCs owners also have the option to be taxes like an S Corp. An LLC owner can file Form 2553 , Election by a Small Business, with the IRS. If approved, an LLC will now be treated like an S Corp by the IRS for tax purposes.
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How S Corporations Work
An S Corporation has a similar business structure to a limited liability company but have distinct characteristics that meet specific IRS requirements.
An S Corp will protect a business owner from certain liabilities just like an LLC. The business is a separate entity from the owner so if there is a lawsuit or debt collection against the company, the owner’s personal assets are protected.
To have your business qualify for an S Corp, it must meet strict requirements set by the IRS. These requirements include:
- No more than 100 principal shareholders or owners
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Owners must be US citizens or permanent residents
- Cannot be owned by any other corporate entity including other S Corps, C Corps, LLCs, business partnerships or sole proprietorships
- Required board of directors
- Required annual shareholder meetings
- Strict regulations on bylaws
- Strict regulations on issuing stock shares
How to Form an S Corp
Forming an S Corporation is similar to forming any other business. Although the formation processes will vary by states, these are the general steps:
Step 1: Name Your Business: Your business needs a unique name that is not already being used by another S Corp in your jurisdiction. You can do a business name search to confirm this.
Step 2: Set Your Board of Directors: Every S Corp is required to have a board of directors. The board of directors is your businesses governing body that represents the shareholders of the company. One of the requirements of forming an S Corp is that this board needs to have regularly scheduled meetings and keep meeting minutes . The board will also develop policies for managing the company.
Step 3: File Articles of Incorporation: When forming an S Corp, articles of incorporation must be filed with both the IRS and the Secretary of State. Each state has specific rules for these filings.
Step 4: Issue Stock: S Corps can be in the form of either common stock or preferred stock.
Step 5: File Corporate Bylaws: Bylaws are another area of the S Corp that is strictly regulated by the IRS. Bylaws will outline the process for electing and removing directors from the board, how shares are sold, when meetings will be held, voting rights, and how the death of a director will be handled.
Step 6: File Form 2553 with the IRS: After your S Corp has been approved by the Secretary of State, you must file the Election by a Small Business Corporation form with the IRS. This is form 2553 and it makes your company official with the IRS.
Step 7: Assign and File a Registered Agent: Depending on your state, you may be required to appoint a registered agent for your S Corp. The registered agent will oversee receiving all legal documents between the company and government agencies.
Pros of an S Corp
S Corps provide several advantages to business owners and these advantages generally outweigh any potential disadvantages.
- Tax Benefits: S Corps are pass-through entities, so they do not have to pay federal taxes at the corporate level. This allows business losses to offset shareholder’s income reducing the amount of taxes paid.
- Liability Protection: Just like an LLC, an S Corp protects the personal assets of its shareholders. A shareholder will not be personally liable for any business debts or company liabilities.
- Credibility : Establishing an S Corp will give your business credibility that it may not gain under a sole proprietorship or an LLC. Suppliers, investors, and customers may be more inclined to work with a corporation because it shows a commitment to not only the company, but the shareholders as well.
Cons of a S Corp
Usually, the advantages to forming an S Corp generally outweigh the disadvantages, but a business owner should be aware of these negative aspects:
- Some states do not allow S Corp income to be taxed on the owner’s personal tax returns
- There are numerous fees associated with an S Corp like filing fees for annual reports and articles of incorporation
- S Corps are more difficult to establish and maintain than an LLC due to requirements of board of directors, annual shareholder meetings, and regulations on stock issuance
- Owner of the company has less control than with an LLC or sole proprietorship
S Corps and Taxes
S Corps are a pass-through entity so instead of being taxed like a corporation, they are actually taxed similarly to an LLC. Business income, losses, deductions, and credits will pass directly to shareholders avoiding federal corporate taxes.
S Corp shareholders will report all financial information relating to the business on their individual tax returns and pay taxes at their regular income rates. This allows shareholders to avoid the double taxation usually associated with a corporation.
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