LLC and S Corp are two expressions you’ll hear a lot when setting up a business. During these early stages you might wonder: what’s the difference?
When starting a business there are a lot of ways to organize your company for tax purposes. Yet, most new startups often end up being classified as either an LLC or as an S Corp. These both offer significant advantages and disadvantages depending on your company size and setup.
In this article, we’re going to explain the key differences between an LLC and an S Corp. Read on to find out what each type of entity is, its pros and cons, and most importantly, which of the two is the right choice for your new business or startup.
What is an LLC?
LLC stands for Limited Liability Company. It is a type of firm often consisting of 2 or more members where those owners have officially filed articles of association with their local state government. It is legally separate from its founders and offers limited liability on any company losses.
In the case of LLCs, income tax and self-employment taxes are levied on each individual member’s share of all profits and financial distributions. In this way, LLCs are taxed similarly to individual partnerships as each member must file their own taxes rather than additionally presenting the company’s taxes independently.
Pros and Cons of an LLC
There are a number of pros and cons of setting up your business as an LLC. Many of these are related to the ease of creating and operating the entity and the need to pay additional taxes.
There are a number of benefits to organizing your company as an LLC. The first of which is simplicity.
Members don’t need to specially file taxes for the LLC entity itself. Instead, they include the profits and distributions in their own tax return.
This makes the whole setup of a new Limited Liability Company much simpler than an S Corporation. It also is a far less expensive process to manage as there are fewer logistical and accounting headaches to overcome.
There are however a few downsides to LLCs. The first is that despite the simplicity in taxation, there are more fees to pay. This is because LLC members get charged income tax as well as self-employment tax.
Furthermore, owners have to also ensure that they keep the LLC as a separate entity to their personal affairs. Failure to do so could lead to them losing LLC status and opening up the possibility of facing unlimited liability for any debts.
What is an S Corp?
First of all, it’s important to know that an S Corp (the name stands for Subchapter Corporation) is a tax classification for an LLC rather than a specific entity in its own right.
The big difference, in this case, is that members of the company are taxed as employees rather than as self-employed. As a result, the company is also taxed as its own entity. This can result in fewer taxes being paid overall.
This is because S Corp owners pay themselves a salary from the company profits rather than taking responsibility for a share of all the assets and revenue and being taxed accordingly.
Pros and Cons of an S Corp
Whilst the extra filing necessities and the need to open the company’s books to the government may put some people off S Corps, there are still many benefits to classifying your company in this way.
S Corp Advantages
The most important advantage is that there are fewer taxes levied against owners. They get to take home a ‘reasonable salary’ which is taxed at an income level only.
Beyond this, any further profits can also be provided to the members as dividends. These are assessed at a lower rate than profits and distributions subject to the self-employment taxes you’d get with an LLC.
S Corp Disadvantages
However, there are a few downsides, notwithstanding the costs of filing taxes as an S Corp. The first key problem is that these entities have stricter eligibility criteria.
Members must be full US citizens and the distribution of profits must be directly proportional to the percentage of capital that each owner has invested. Additionally, there are limitations on the number of shareholders an S Corp can have, with a cap of 100 members.
There is also a limit on “passive income” on assets such as real estate and there can sometimes be additional state taxes. These are all issues that owners should be fully aware of before opting to start an S Corp.
Finally, the management of an S Corp requires a greater level of formality than a regular LLC. You need to hold regular company meetings and report more of your company’s financial dealings to your state. This can sometimes also lead to paying further taxes to your local state.
What is Better for Taxes, an LLC, or an S Corp?
There is no single answer to this question. You’ll usually find that the decision to classify your business as either an S Corp or an LLC will ultimately depend on the type of company that you’re running.
If your company is fairly large and makes regular profits you may find an S Corp works better for you. This is also the perfect step if your company is starting to grow fast but isn’t yet ready for the complexities and costs of filing articles of incorporation and moving to a full corporate structure.
An LLC however is ultimately your best choice when you only have a few individual members and you want to simplify the tax filing process. This is normally better for small to middle-sized companies.
LLC vs S Corp: Which Should You Choose?
When making your final decision on whether to classify your company as an LLC or S Corp, it’s important to look at a number of crucial factors.
When starting out it is often better to form your business as an LLC. Revenue in the first few years is often more variable than with an established company. If you expect to make little income at first it’s best to keep things simple as you won’t be able to reap the benefits that S Corps often bring to profitable, settled businesses.
You might find further down the line that as your revenues increase and your business grows, your taxes also balloon in siz as an LLC. When this becomes the case, the time could be right to switch to an S Corp classification.
When you start your LLC you will need two key legal documents. You will need to complete and file the articles of organization with your local state and you will need to write up an LLC operating agreement for your company records.
LawDistrict can help you prepare your own LLC operating agreement today. Simply complete our step-by-step survey to create a professional and effective operational outline for your new business.