S-Corp vs LLC: Which is Right for My Business?

  • by Brandon Boushy
  • 2 months ago
  • Blog
  • 0
A man searching online about S-Corp and LLC

Did you know an S-Corp can create considerable savings compared to an LLC? An S-Corporation (S-Corp) and a Limited Liability Company (LLC) are both excellent choices for business structures, but once you hit $100K net income, an S-Corp might reduce your tax load.

UpFlip is here to help you choose between an S-Corp vs an LLC. We’ll explain what to consider when choosing one business structure over another, what LLCs are best at, what S-Corporations do best, and what they have in common.

We’ll also explore frequently asked questions between an S-Corp and an LLC. 

What is a Limited Liability Company?

According to the National Small Business Association’s (NSBA) 2017 Year-End Report, an LLC is the most common business entity. Thirty-five percent of businesses opt for this business structure. The primary reasons people choose an LLC include: 

  1. Separation of business and personal assets
  2. Ease of forming an LLC 
  3. Separation of personal and business liabilities
  4. Ability to choose your tax structure
  5. Pay self-employment tax

Keep reading to learn what an S-Corporation is and why people use it.

What is an S-Corp?

An S-Corporation isn’t a business entity but a tax filing status. Despite this technicality, 33% of small businesses are S-Corps, according to the same NSBA report. 

An S-Corp files taxes using Subchapter S of the Internal Revenue Code. Click the link to view the current version of the S-Corporation tax code.

You must meet the following requirements to form an S-Corp:

  1. Have less than 100 stockholders
  2. Run an LLC or C-Corp
  3. Be a U.S. resident
  4. Maintain one class of stock
  5. Pay the business owner a reasonable salary
  6. Pay half of the 15.3% payroll taxes

S-Corporations are predecessors to LLCs, according to Law Shelf. People also call an S-Corp by the names:

  • Sub S-Corporation
  • Small business corporation

Difference between LLC and S-Corp

There are a handful of differences between LLCs and S-Corporations. Some of the most important differences include:

  • An LLC is a business entity. At the same time, an S-Corp is a tax filing status.
  • An S-Corp treats business income differently than a default single-member LLC.
  • An LLC provides more tax options than an S-Corp.
  • LLCs have fewer compliance requirements.
  • LLC owners pay self-employment taxes, but S-Corps use payroll taxes.

LLC vs S-Corp: Entity Status

Because an S-Corp is a filing status as opposed to a type of business formation, an LLC is by far the more efficient business structure unless you want to take advantage of the S-Corp dividend abilities.

That means you’d need to go through creating an LLC or a C-Corporation before you can even start an S-Corp. S-Corporations were heavily used before LLCs became a business structure because of the limited liability protection to professionals without the far more significant complication of C-Corp status.

LLC and S-Corp: Business Formation

The formation of Limited Liability Companies and S-Corps can be relatively similar. Let’s look at the requirements for each to understand the differences and similarities.

Forming an LLC

A man holding an iPad and taking notes

An LLC will have several main requirements to create and maintain it. You’ll need to:

  • Pay the filing cost
  • Pay ongoing fees
  • Write an operating agreement
  • Submit the articles of organization
  • Get an EIN

We’ll look at the filing costs, operating agreement, and the articles of organization because they are unique to an LLC.

Filing Cost and Ongoing Fees

To form an LLC, you need to register with the Secretary of State (SOS) in the state you plan to operate. You can find your state’s SOS by using the government agency finder on USA.gov.

Paying the filing cost will require a fee at the state level. None are over $500, and most are under $300, but you’ll also have to pay ongoing fees that range from $0 annually to $500 annually. The lowest fees to maintain an LLC are in Pennsylvania, which typically costs $70 every ten years.

Operating Agreement

An operating agreement states how the business will function. When you file this document with the SOS it provides the benefits of:

  • Personal liability protection
  • Making verbal agreements legally enforceable
  • Setting rules that are different than your state’s default rules for LLCs

An operating agreement is mandatory in California, New York, Delaware, Missouri, and Maine. Others may give you the option to include one, but those states require one. An operating agreement includes:

  • The creation date
  • Location
  • Owners and percentages
  • Management and voting interests
  • Investment in business
  • How profits, losses, and assets, are distributed
  • A succession plan
  • A dissolution plan
  • And anything else required by your state.

You’ll need to sign and notarize the operating agreement. Create an LLC through our partner BetterLegal to save $30.

 Let’s look at the Articles of Organization next.

Articles of Organization

The Articles of Organization are very similar to the operating agreement, but you must submit the document to the Secretary of State’s office. They include:

  1. Company name
  2. Description of the company
  3. Mailing address
  4. Name and address of the registered (or statutory) agent
  5. Information about company owners, managers, and officers

The most common reason for rejecting an LLC application is that someone else is using the name.

Forming an S-Corporation

A man holding an S-Corp checklist

An S-Corporation will first require starting a business entity with your state’s SOS. You may opt to create an LLC or C-Corp as your business entity. Then you’ll need to file Form 2553 with the IRS to opt to be treated as an S-Corp.

There should be less than 100 stockholders, and they can’t be foreign residents or several types of legal entities. UpCounsel explains which legal entities can and cannot hold S-Corp shares, but each one may need to be considered on a case-by-case basis. These restrictions are significant drawbacks of an S-Corp. 

Unless some of the following sections impact your company, I recommend starting with an LLC and opting for an S-Corp when the benefits outweigh the costs. 

LLC or S-Corp: Treatment of business income 

How LLCs and S-Corps treat taxable income varies dramatically. Significant differences include:

  1. Owner employee classification
  2. Profit treatment
  3. Treatment of Fica
  4. Tax code(s) used

We’ll look at each in more detail.

Is the owner of an LLC required to pay self-employment tax?

By default, the government classifies an LLC owner as self-employed, which means the owner:

  • Claims the profit or losses as personal income, which is called pass-through income.
  • Pays the full 15.3% Federal Insurance Contributions Act (FICA) taxes.
  • Follows the same tax code as a sole proprietor or partnership.
  • May choose to file taxes as an S-Corp or C-Corp and file based on their tax codes.

An S-Corp owner will treat their income differently. Their income is treated two ways depending on whether they are actively involved in the company. Let’s look at each.

How is an S-Corp owner’s income treated when they run the business?

If you actively work in your S-Corp, there are three types of income.

  1. A reasonable salary: Must pay comparable to the Bureau of Labor Statistics Median Income or higher for your role. Find the appropriate wage.
  2. Losses: Treated as pass-through income, reducing your net income.
  3. Profits: Profits are treated as dividend income and have three tax brackets: 0%, 15%, and 20%. You don’t pay FICA on dividends.

The salary will be subject to 7.65% payroll tax taken out of your paychecks and 7.65% that comes out of the S-Corp revenue and is considered an expense, which reduces dividends.

You’ll be following a different tax code and filing different forms.

S-Corp Owner as a Stockholder Only

A man at his desk searching online

If you are not actively involved in the management of an S-Corp, you do not have to include a reasonable salary. You only have to include losses and profits based on the following:

  • Losses: Treated as pass-through income, reducing your net income.
  • Profits: Profits are treated as dividend income and have three tax brackets: 0%, 15%, and 20%. 

This strategy can be beneficial if you pay others to run the company and do not want to be taxed based on FICA and personal income brackets. Depending on your role in the business, net income, and other factors, an S-Corp can have considerable benefits over an LLC.

The benefits become tremendous once you have reached a net income greater than the median wage for a comparable position. All profit from the S-Corp will be dividends, reducing your tax load. We’ll discuss tax benefits next.

S-Corp vs LLC: What Are the Tax Benefits?

Both an LLC and an S-Corp have benefits that create tax savings depending on your company’s profits and the number of business owners. The table below shows an S-Corp’s tax savings over an LLC assuming $500,000 income before taxes.

Comparisons Using Operations Manager Median Pay of $180,000
LLC (Default)Working in S-CorpS-Corp Dividends Only
Net Income/Salary$500,000$180,000
Minus FICA$18,228$9,114
Minus Income Tax$148,75337831.5
Dividends0$320,000$500,000
Minus Dividend Taxes0$41,749$70,761
After Taxes$333,019$411,306$429,239
Effective Tax Rate33.40%17.74%14.15%

We’ll discuss the benefits of each now.

What are the tax considerations of an LLC?

An LLC owner has several considerations for taxes if using the same tax code as a sole proprietorship or partnership, including:

  • 15.3% self-employment tax is broken into 12.4% for social security and 2.9% for Medicare.
  • Pay personal income tax rates of up to 37%.
  • Benefits like Health care are tax-deductible in pass-through taxation.
  • Pass-through LLCs can deduct 20% of net income before being taxed.

An LLC can also file as a C-Corporation or an S-Corporation by filling out the appropriate documentation. Please read up on LLCs on the IRS website to learn about their tax treatment.

From a tax standpoint, the benefit of an LLC is the ability to choose whether filing like a sole proprietor or corporation is best for the business owner. Choose the one with the least tax consequences.

When you own an LLC, pass-through taxation is easier because you only pay personal taxes to the Internal Revenue Service. However, business entities can see even more benefits through the S-Corp election. Let’s look at that now.

What are some tax considerations when electing S-Corp status?

S-Corporations have more tax requirements than an LLC, but less than a C-Corp. S-Corps don’t pay corporate taxes, but they do have to file a tax return. The requirements for an S-Corp include:

  • 1120S: Documents income, gains, losses, deductions, and credits.
  • 1120W: Estimated tax form that is required if a corporation elected S-Corp status.
  • Employment taxes: The company will collect and pay payroll taxes, which are the same rate as self-employment taxes, but the company and employee split the cost. They are also responsible for federal unemployment tax.
  • Excise taxes: Charged on industries like energy, gambling, and tanning booths.

Meanwhile, stockholders will have special requirements for their personal tax returns, including:

  • 1040: This form is to claim income and losses from S-Corps, estates, trusts, etc. 
  • 1040SR: Alternative form 1040 for those over 65 filing their personal tax returns.
  • 1040ES: Quarterly estimates for business owners’ personal tax returns.

I suggest reviewing Schedule E and other S-Corp requirements with a licensed tax professional. Information in this blog should not be considered income tax advice.

While there are more requirements for S-Corp tax status, the S-Corp tax rate is zero. That means you get most of the benefits of a corporation without the corporate income tax. 

If you have to pay taxes, an S-Corp tax treatment definitely beats an LLC once an LLC is taxed at the 25% tax bracket or higher.

LLC vs S-Corporation: Operations

The operation of an LLC or a business electing S-Corp status is similar, except 

  • An S-Corp has to manage payroll taxes.
  • An S-Corp has more legal requirements, which take time.
  • An LLC taxed for self-employment tax is done on a personal income tax form unless the LLC has other employees. 

Which is better, LLC or S-Corp? A small business will have fewer operating requirements as an LLC vs corporation requirements. You’ll want simpler operations when starting a business because there is a long learning curve.

LLCs and S-Corporations: Compliance

A man pointing to his iPad

LLCs have a much easier time complying than an LLC elected as S-Corp. Unfortunately, the tax classification is the main reason for selecting S-Corp status, but it is also the cause of increased compliance requirements.

If you consider having your LLC taxed as S-Corp, I would recommend getting several estimates from licensed accountants of how much it will increase your costs.

If the tax savings are more significant than the additional costs, you can save a lot of money on taxes. Use the formula above to determine whether the transition makes sense for you. An S-Corp is one of the types of businesses that makes the most after-tax-profit as long as you plan on staying under 100 stockholders.

Frequently Asked Questions about LLCs and S-Corps

The following sections answer some of the most commonly asked questions about S-Corp and LLC business structures.

Is an LLC a corporation?

An LLC is not a corporation. A corporation can sell stock in the company, while an LLC cannot. An LLC may opt to file taxes as either an S-Corp or a C-Corp. LLC owners can file with the IRS to opt into one of the tax structures. The forms to file are:

Can an LLC be an S-Corp?

An LLC can be an S-Corp by filing Form 2253 with the IRS.

What is an S-Corporation?

An S-Corporation isn’t a business entity but a tax filing status. Despite this technicality, 33% of small businesses are S-Corps, according to the same NSBA report. 

An S-Corp follows Subchapter S of the IRS Tax Code. To become an S-Corp, your company must:

  • Have less than 100 stockholders.
  • Be a C-Corporation or LLC.
  • Be wholly owned by U.S residents.
  • Have one class of stock.

Can an S-Corp own an LLC?

Yes. LLC owners can be any combination of people or legal entities in most states, but some states may have restrictions. You can view the requirements on their Secretary of State (SOS) website. Use USA.gov to find the link for your state’s SOS office.

S-Corp vs LLC for real estate?

Real estate professionals may want to file as an S-corp instead of an LLC because tax benefits can reduce your tax rate. As an employee of an S-Corp, you have to assign yourself a reasonable salary, but the S-Corp pays profits as dividends, which have a lower tax rate. 

You’ll want to use an S-Corp vs LLC calculator to establish whether it makes sense to create an S-Corp.

How does an LLC become an S-Corp?

An LLC becomes an S-Corp by filling out Form 2553 and filing taxes using guidance from the IRS.

How to revoke an S-Corporation election?

A man holding a big white envelope

To revoke S-Corp status, you’ll need to send a statement of revocation to the IRS. You can find more information about revoking S-Corp status on the IRS website.

S-Corporation vs LLC: So Which Should You Choose?

You can’t go wrong choosing to form an LLC or electing S-Corp tax classification. Both are highly beneficial to small business owners because they each offer liability protection for business owners’ personal assets.

The main difference between the two is income taxes once company profits pass median income for a comparable position. While I am not licensed to give legal advice, I would personally start with a single-member LLC, then move to an S-Corp after reaching a level where the income taxes are reduced S-Corp status.

If you still aren’t sure which structure to use, I suggest reading our other blogs about choosing a formal business structure.

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