Business Law

LLC vs S Corp - Tax & Liability Differences

Tax & Liability Differences Between an LLC and an S Corp test

When forming a new business or changing the structure of your current business, it is important to determine what type of entity is right for you. For a small business owner, avoiding heavy taxes and separating your personal assets from the business are important factors to consider. The best options for small businesses are usually an LLC or an S Corp. Learning about the differences between the two is an essential part of business formation.

What is an LLC?

A Limited Liability Company (LLC) is a business structure designed to combine the limited liability elements of a corporation with the tax efficiencies of a partnership. In an LLC, the owners of the business are called “members.” There can be an unlimited number of members. The members of an LLC do not have to be U.S. citizens. Members or managers can run the day-to-day operations of the business. The personal assets of the members of an LLC are protected against debts or losses related to the business. An LLC requires fewer forms for registration and has fewer start-up costs. If a member dies or goes bankrupt, the LLC must be dissolved. If you decide to make your company public, you would need to convert to a corporate business structure.

What is an S Corp?

An S Corporation (S Corp) is a corporation that has received a Subchapter S designation from the IRS. Before your business can become an S Corp, it must be chartered as a corporation in the state where it is headquartered. An S Corp is considered to be separate from its owners, or “shareholders.” An S Corp can have no more than 100 shareholders. Non-citizens cannot be shareholders in an S Corp. It is possible that, in a lawsuit, a shareholder’s personal assets could be in jeopardy. If a shareholder dies, leaves the company or sells their shares, the company can continue with little disruption. A board of directors handles major decisions while elected officers handle daily business matters.

Tax consequences of LLCs and S Corps

In an LLC, members have to file taxes only once a year. In a single-member LLC, a Form 1040 and a Schedule C must be filed, as with a sole proprietorship. If your LLC has partners, you must file a Form 1065 partnership tax return like the owners of a traditional partnership. The owner of an LLC is considered to be self-employed, meaning you must pay the 15.3% self-employment tax toward Medicare and Social Security. The entire net worth of the business can be taxed.

In an S Corp, it is possible to have the profits and losses of the business go through the shareholders’ personal tax returns. The business itself is not taxed. The shareholders must pay themselves “reasonable compensation.” In an S Corp, only the wages of shareholders are subject to employment taxes.

Formalities in S Corps and LLCs

S Corps have more required internal formalities than LLCs. The shareholders of an S Corp must do the following:

  • Adopt bylaws
  • Issue stock
  • Hold annual director and shareholder meetings
  • Keep meeting minutes

In an LLC, while not required, the following formalities are recommended:

  • Adopting an operating agreement
  • Issuing membership shares
  • Holding annual member meetings
  • Documenting member meetings
  • Documenting all major company decisions

Which should you choose?

There are pros and cons to starting either an LLC or an S Corp. Both provide liability protection for members or shareholders. If you are looking to have a more flexible business structure with less paperwork and the ability to sell interests in the company, an LLC is the right option for you. If you want a more rigid management structure that may seem more legitimate to potential investors and allows you to sell stock, choose an S Corp.

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