S Corp vs. LLC

Two important terms you’ll see when researching how to set up your new business are LLC and S corp. They’re very different things, but they both impact how your company will be taxed. This article will help you understand S corp vs LLC and the advantages and disadvantages of each.

The difference between S corp and LLC is so stark because, for starters, they’re not even in the same category. A limited liability company (LLC) is a type of legal business entity. But an S corporation (S corp) isn’t a business entity at all. It’s a tax status that an LLC or a corporation can apply for with the IRS if it meets certain criteria. For an LLC, filing as an S corp has the potential to save the owners a great deal in self-employment taxes.

For the purposes of this article, we’ll be comparing a typical LLC and an LLC with S corp tax election. If you’d like to know more about how each of them compares to a corporation, see our S Corp vs. C Corp page and our LLC vs. Corporation page.

What is an LLC?

An LLC is a legal business entity that provides limited liability protection, meaning that the owners (who are called “members” in an LLC) are usually protected from the business’s liabilities and debts. That simply means that if someone sues the business or the business goes into debt, the personal assets of the LLC members are protected in most cases. 

Corporations also have liability protection for their owners (“shareholders”), but corporations usually have to deal with the “double taxation” of corporate income tax. Basically, when the corporation makes a profit, the corporation itself is taxed on the profits. Then, when the company profits are distributed to the individual shareholders, the profits are taxed a second time. 

LLC owners, though, can avoid this double taxation by being taxed as a sole proprietorship or general partnership. In that case, the LLC itself isn’t taxed on profits; the members only pay personal income tax on the profits on their individual tax returns. This is called “pass-through” taxation.

Furthermore, LLCs also have the option to be taxed as a corporation if they prefer. They can elect to be taxed as a C corporation (the default form of corporation) or an S corporation (which we’ll get to in a second). Being taxed this way can have tax benefits for some LLCs.

This flexibility in LLCs also carries over to how LLC owners can organize and run their business. The law requires corporations to appoint a board of directors and have extensive record keeping, operational processes, and reporting. LLCs have far fewer requirements.

What is an S corporation?

As we explained, “S corp” refers to a tax filing status an LLC or corporation can apply for with the IRS. S corps are geared toward small business owners, so they have certain restrictions, such as having no more than 100 owners and some others we’ll cover later. A business with S corp election has pass-through taxation like a typical LLC when it comes to federal income taxes.

So, why would an LLC, which already has pass-through taxation, want to be an S corp? It has to do with self-employment taxes, which are the taxes a self-employed individual pays for Social Security and Medicare.

The members of a normal LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they aren’t allowed to be employees of the LLC. Being self-employed requires members to pay self-employment tax (about 15.3%) on all profits they receive from the LLC. This is more than the taxes they’d pay when working for someone else because their employer would pay half of them.

But when the members elect S corporation status, they can be compensated in two ways: by receiving their share of the profits and by being paid as an employee of the LLC. Once they do that, they only pay self-employment tax on their salary and not the profits they receive. (Of course, this is only for self-employment tax; LLC members still must pay income and other applicable taxes on the business income.) This can add up to quite a lot for certain profitable LLCs. 

One caveat to this is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $10 and avoid contributing anything to Social Security and Medicare. 

What is the difference between LLC and S corp?

As we said, an LLC is a legal business structure, whereas an S corp is a tax filing status. But let’s compare a standard LLC to an LLC with S corp election. First, we’ll examine the advantages an LLC with S corporation election has over an LLC without S corporation election.

Advantages of S Corp Over LLC

As we just explained, the members of a standard LLC can’t be employed by the business. The money they make from the LLC comes from distributions, a.k.a. their share of the profits. They must then pay 15.3% in self-employment tax on all those profits. If the LLC is particularly profitable, that can add up to a sizeable chunk of change.

An LLC with S corporation election can pay its members in two ways, in distributions and a salary from the LLC. In that case, the members would only pay employment taxes (Social Security and Medicare) on their salary from the LLC, but not on the distributions. Again, in a more profitable business, the tax savings can add up. Money paid out as salary is also a tax-deductible expense for the business. 

Advantages of LLC over S Corp

Traditional limited liability companies also have some advantages over those with S-corp election:

Requirements for S Corporations

The Internal Revenue Service (IRS) has stricter requirements for businesses with S corp designation. For an LLC or corporation to qualify for S corporation election, the Internal Revenue Code says they must:

• Be a domestic corporation or LLC
• Have no more than 100 shareholders or members 
• Have only allowable shareholders or members, which includes individuals, certain trusts, and estates. The shareholders may not be partnerships, corporations, or non-resident aliens; a nonresident alien is an alien who has not passed the green card test or the substantial presence test. However, an S corp can own other businesses.
• Not be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations
• Have only one class of stock

As you can see, these restrictions would limit the number and type of members an LLC set up as an S corporation could have. A traditional LLC could have more than 100 members and be owned by corporations, partnerships, and non-resident aliens.

More IRS Scrutiny

Remember what we said about LLC members being required to pay themselves a “reasonable salary”? The IRS watches this closely to prevent abuse. If your salary is inadequate, you’re not contributing enough to Social Security and Medicare.

That’s why the IRS expects you to pay yourself a reasonable salary. But how does the IRS define “reasonable compensation”? The instructions on Form 1120-S read, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”

While those instructions don’t provide a 100% clear definition, the IRS seems to consider “reasonable” to be something similar to what others in your field are earning for the same work.

All of this means that a business with S corp designation is more likely to be audited than one without. And, if the IRS decides that your salary is not reasonable, it has the authority to reclassify your non-wage distributions (which are not subject to employment tax) to wages (which are subject to employment tax). Several court cases have supported the IRS’s right to do this.

Additional Accounting and Bookkeeping

Having an LLC filing as an S corporation generally means more paperwork. If you don’t already have to do payroll and calculate payroll taxes for your business, being an owner-employee means that you’ll have to do so. Your taxes will be more complex, as well.

With these added complications, you’re likely to have higher administrative costs. You may find that you need an accountant, bookkeeper, and/or a payroll service or software.

How We Can Help

Now that you understand the difference between LLC and S corp, you’ll have to weigh all the factors to see which choice best fits you and your business. We don’t recommend doing this alone, though. It’s times like these when you need a skilled tax professional to help you make an informed decision.

If you’re planning to start an LLC, with or without the S corp designation, we can handle the process for you. Our LLC formation service sets you up with experts who can file the paperwork with the state for you. And, if you’d like to form your LLC as an S corp, our S corporation service can take care of that added step, too. Once you’re established, we have other services like Worry-Free Compliance to help you stay compliant with government regulations.

You can do this. We can help.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.