When choosing a business form, business owners who want pass-through taxation often end up deciding between an S corporation and an LLC. These are both popular business entity choices for a closely held business or solopreneur.
As this article explains, limited liability companies and S corporations have some characteristics in common but are very different in other ways. One business entity may be a better option than the other depending on what is important to your business.
You may prefer an S corp if you:
You may prefer an LLC if you:
Ultimately, you should talk to your advisor before deciding which form of entity to choose, but here are some things to keep in mind as you consider your options.
Note: An S corporation is a corporation whose shareholders elect to be taxed under Subchapter S of the Internal Revenue Code rather than Subchapter C. Although they are different for tax purposes, there is no difference between S and C corporations as a business entity under the state corporation laws. Similarly, while an LLC is taxed by default like a sole proprietorship if it has one member and like a partnership under Subchapter K if it has more than one member, the members can elect to have the LLC taxed under Subchapter C or Subchapter K. But the state LLC laws make no distinction based on an LLC’s tax status.
LLCs and S Corps have their own legal existence. And their existence is separate from the people who own them. A corporation is formed by filing articles of incorporation with its state of incorporation. To be taxed as an S corporation it then has to file an election form with the IRS. An LLC is formed by filing articles of organization with its formation state. (If the member or members do not want it to be taxed under the default rules it will also have to file a form with the IRS). Once formed both S corporations and an LLCs will have to maintain a Registered Agent, file annual reports, maintain good standing with states, comply with business license requirements, and so forth.
Both LLCs and S corporations offer their owners limited liability protection. This is one of the main reasons to incorporate or form an LLC to own a business rather than owning it yourself.
If you run your business as a sole proprietorship or general partnership, then business creditors can reach any of your assets, even if those assets have absolutely nothing to do with the business. But because corporations and LLCs are separate business entities from their owners, the entities (not the owners) are responsible for the business’s debts, liabilities and obligations. The liability of the corporation’s shareholders and the LLC’s members is limited to their investment.
Note: Owners of an LLC or corporation (S corp or C corp) can lose liability protection in certain cases. Read Piercing the Veil of Small Business to learn more.
When it comes to federal income taxation, S Corps and LLCs both offer their owners pass-through taxation. This means that business income and losses are not taxed at the company level, but “pass-through” to the owners and are reported on the individual’s tax returns. This avoids the “double taxation” imposed on C Corporation dividends that are taxed at two levels: the corporation and shareholders.
But it is important to keep in mind that even though LLCs and S corps are pass-through tax entities they are governed by very different federal income tax rules. So they are not identical when it comes to how they are taxed.
One of the reasons many people prefer the LLC over the corporation is that there is more flexibility in how it is managed.
Corporation laws (which, as noted apply equally to S corps and C corps) contain more provisions regarding managing the company than LLC laws. For example, corporations must hold an annual shareholders’ meeting, directors’ meetings are required, proper notice must be given and minutes taken, etc. LLC statutes do not have similar requirements.
In addition, LLCs can be managed by the members or by managers. Corporations are managed by a board of directors. Shareholders do not manage the business and affairs of corporations.
Another advantage of the LLC is that there is greater flexibility in splitting up financial interests. Owners of LLCs can allocate profits and losses disproportionately among owners; an S corporation’s profits and losses must be allocated strictly based upon ownership percentage. If multiple LLC owners have different roles in the business, this could be especially beneficial.
For a solely owned business an LLC, because it can be disregarded as an entity for tax purposes also offers the advantage of being able to include your business income and loss on your Form 1040 individual federal income tax return. (In other words, business income is taxed on your individual income tax return as if you were a sole proprietor and your LLC does not have to file a separate return.)
This option disappears if the LLC has more than one owner and is taxed as a partnership. In that case a separate partnership return has to be filed with the IRS. (Although it is only an information return as the LLC does not pay taxes).
A major advantage of the LLC over the S corporation is that it can provide pass-through taxation without having to meet the requirements of Subchapter S. In order to make the election to be an S corporation, the corporation:
The IRS restrictions never end. At any time, violating these rules will jeopardize your pass-through taxation.
An LLC can achieve pass-through taxation status by being disregarded if it has one member and by being taxed as a partnership under Subchapter K without any of the Subchapter S restrictions.
LLCs also offer more income tax choices in how you are taxed. Not only can it be disregarded or taxed like a partnership but by making an IRS election, you could have your LLC taxed as a C corporation or an S Corporation. A strong caveat here — which you should discuss with your tax advisor — is that if an LLC elects S Corp taxation, it still has to satisfy all the S Corp tax rules and states differ in how they treat the IRS election.
S corporations have some advantages over LLCs. Because an LLC can also be taxed like an S corporation, these advantages are based mainly on the differences between corporations and LLCs in general. It can be easier to obtain outside funding as some investors and banks prefer to invest in corporations than LLCs because corporations are generally better for recapitalizing and reorganizing over time as a business grows. Being a corporation is also still considered more of a status symbol. And because corporations have been around so much longer than LLCs they are more familiar to the lawyers and other professionals who will be providing advice.
Another advantage is ease of conversion to a C corporation. To convert from S corp status to C corp status simply requires the filing of a form with the IRS. As noted, the state corporation laws do not distinguish between S corps and C corps so there is no filing necessary with the state’s business entity filing office.
However, LLCs and corporations are totally different entities. In order to go from an LLC to a C corporation, you will have to either merge the LLC into a corporation, enter into a statutory conversion or dissolve the LLC and incorporate. You may want to do business as a corporation rather than an LLC, for example, if you anticipate raising capital by selling shares of stock, seeking funding from venture capitalists or private equity funds, or by going public.
As you can see, both the LLC and the S corp have their advantages and disadvantages.
Between an LLC and an S corporation, there is no single choice that is always better for every business owner. The best option depends on each individual owner’s current needs and future plans. Working with a business professional is the best way to determine which is best for you: LLC or S Corp.
