Understanding the difference between an LLC and an S-Corporation can be challenging for many entrepreneurs.
In today’s post, I’ll give you the information you need to make an informed decision about whether your business should be an LLC or an S-Corporation. You might even find that neither or both options could be the best choice for your business!
What is the difference between an LLC and an S-Corporation?
I get asked this question a lot, so I will break this down as simply as I can. Basically, any differences in the way these businesses are run and taxed stems from the fact that an LLC is a limited liability company and not a corporation.
The three major differences between an LLC and S-Corp are:
- They require different tax return forms,
- Electing to have a S-Corporation status reduces self-employment taxes, and
- S-Corporations must pay their employees reasonable compensation, which could mean payroll processing expenses.
I should also note that in terms of taxes, there are also some differences that have to do with the Section 199A qualified business income (QBI) deduction. Your accountant can explain to you whether it would be better for your LLC to make an S-Corp election in order to get the most out of the Section 199A deduction.
Do I have to have an LLC to run a business?
Nope! Basically, once you decide to have a business and you make your first sale, then bam! You’re in business, baby! What you have is called a sole proprietorship.
If you decide that you want or need more liability protection for your business (to separate your personal liability from the business’ liability), then you can form a limited liability company to help protect yourself. However, this is not required.
Additionally, although some people might tell you that having an LLC saves you money in taxes, that’s not true either. Whether you have a sole proprietorship or an LLC, you have to elect to have S-Corporation status in order to get the tax savings from being a pass-through entity.
What is a pass-through entity?
When you elect to be taxed as an S-Corporation on your federal taxes, you’re saying that you want to be taxed as a pass-through entity. This means that the business’ income, deductions, taxes, and credits are passed directly on to the owners, shareholders, or investors to be taxed on their individual tax return.
Pass-through taxation helps you avoid double taxation that would happen if your business income was taxed at the business level and then again on your individual tax return. In other words, electing to have pass-through taxation as an S-Corporation can save you lots of money in taxes.
Additionally, many states have also enacted pass-through entity tax (PTET), so make sure you speak to your accountant about your state income tax options as well.
How do I form an LLC?
The first thing to understand is that an LLC is a business structure or entity, which means it’s a type of business. On the other hand, an S-Corporation is really a tax classification for federal tax purposes. This happens when a corporation or certain LLCs choose to be taxed using pass-through taxation. So you can create an LLC and then elect to have it taxed as an S-Corporation, but you don’t have to have an LLC to file for S-Corporation status (more on that in a minute).
Forming an LLC and electing to have your business taxed as an S-Corporation are two separate processes. The LLC formation is typically straightforward, but it does take some time, and your state sets the rules (usually your Secretary of State’s office), so it’s smart to work with an accountant or business attorney that can help you navigate your state’s requirements.
Additionally, when forming an LLC, your state may require you to complete these steps:
- Choose and assign an official business name
- Apply for a federal Employee Identification Number (EIN)
- Assign a registered agent
- File Articles of Organization (or a similar document, depending on your state)
- Create an operating agreement
- File for appropriate licenses and permits
- File required paperwork with the state
- Pay fees to the state
- Open a business banking account
How do I form an S-Corporation?
Electing S-Corporation status can be a little more complicated than forming an LLC, and your business must meet certain requirements in order to qualify for S-Corp status, such as:
- Must be owned by individuals who are U.S. citizens or permanent residents
- Must not have more than 100 principal shareholders or owners
- Must not be owned by another S-Corporation, C-Corporation, LLC, or business partnership
- Must have a permanent address in the U.S.
- Must have only one class of stock
- Must not be an ineligible corporation like a domestic international sales corporation or insurance company
If you meet the government’s requirements for obtaining S-Corp status, you’ll complete IRS Form 2553.
Then, you’ll also need to meet other requirements to complete the process and keep your status, such as:
- Choose and assign an official business name
- Apply for a federal Employee Identification Number (EIN)
- File Articles of Incorporation with your state
- Determine a reasonable compensation (salary) to pay yourself and employees
- Schedule meetings for directors and shareholders and keep meeting minutes
- Create corporate by-laws
- Issue stock certificates
- Maintain accurate business records
- File for appropriate licenses and permits
- File required paperwork with the state
- Pay fees to the state
- Open a business banking account
Even though it may sound like a lot of work to elect S-Corp status, many of these things you likely already do in some shape or form and some of the tasks only need to be completed once. Keep in mind that the tax benefits for electing S-Corporation status can be huge, so it’s definitely worth the effort in most cases.
One more thing to consider at the state level is that several states have small subtleties in the law that make the way you set up your business even more important. For instance, in California, corporate officers of LLCs taxed as S-Corporations must pay State Disability Insurance, whereas officers in corporations taxed as S-Corporations don’t have to pay for that insurance.
Because there are so many details you want to get right when electing S-Corporation status, I highly recommend that you work with an attorney or a certified public accountant who is experienced in this area.
Should I elect S-Corporation status?
Whether or not you should elect S-Corporation status for your federal taxes depends on several factors. The first factor that can clue you in is your net income.
If you’re netting between $50,000 and $60,000 for the year, then you would likely benefit from the S-Corp election. This is because around $50,000 is when the expenses associated with having an S-Corporation are outweighed by the tax savings you’ll see from pass-through taxation.
If you’re not sure yet, you can wait until later in the year to decide to make the election. Actually, you can sometimes wait and do a retro election (if you meet certain requirements) for the past 3½ years. This is something you’ll definitely want to discuss with an accountant to make sure you don’t miss any important deadlines for paperwork.
Abridged by Amy
Weighing the pros and cons of business structure and tax status decisions is an important step in creating and maintaining a successful business. It can also be an important step in lowering your tax bill!
My passion is helping entrepreneurs take charge of their business finances so they can keep as much money as possible in their bank accounts. So if you found this article helpful, here are some other free blogs I’ve written to help business owners just like you:
- Choosing the Right Business Structure
- Pros and Cons of a Single-Member LLC
- Pros and Cons of Sole Proprietorship
- S-Corp Advantages & Disadvantages: The Complete Guide
- Can an S-Corporation Own an LLC?
P.S. You can find all of my blog posts for S-Corps right here!
