LLC vs. S Corp – Differences and Tax Implications
The structure you select for your business significantly impacts several crucial business issues. This includes liability exposure, financing, business growth, tax implications, and more.
Among all the different business structures, LLCs and S Corp are very popular. Both the structures offer limited personal asset protection along with pass-through taxation.
But while both the structures offer this basic business benefits, there are many essential differences between them.
For instance, do you know that S Corp is not really a business structure? Yes, S Corp is just a taxation method for LLCs, and it is not a business structure like LLC or a Corporation.
Moreover, while LLC is a business structure, there is nothing known as an LLC tax structure. An LLC has to select one of the tax structures from options such as disregarded entity, Corporation or partnership.
Confusing, right? Read this post, and you will understand the differences between the two better.
- What is an LLC?
- What is an S Corp?
- LLC vs. S Corp
- Taxation of LLC and S Corp
- Taxation as a Disregarded Entity (Single-Member LLC)
- Taxation as a Partnership (Multi-Member LLC)
- Taxation as an S Corp (Single-Member and Multi-Member LLC)
- Who Pays More Taxes? LLCs or S Corps?
- So, Why LLCs Choose S Corp Tax Structure?
- Can Every LLC Be an S Corp?
- How to Select Between LLC and S Corp?
What is an LLC?
An LLC or a Limited Liability Company is a state-registered business entity. LLCs are legally separate from their owners (known as members). LLCs can have a single owner or multiple owners.
Most small businesses prefer LLC structure as it is more credible than sole proprietorship and offers more flexibility in comparison to a Corporation.
What is an S Corp?
While LLC is a business structure, there is no business structure known as S Corp. It is only a designation which refers to how a business pays its taxes.
If you have an LLC, you get the option to select between different tax structures. These options include disregarded entity and Corporation (S Corp or C Corp) for single-member LLCs. If you select the disregarded entity, your taxation will be similar to a sole proprietorship.
For multi-member LLCs, the options are partnership or Corporation (S Corp or C Corp).
LLC vs. S Corp
There are several similarities between LLCs and S Corps such as-
- Both are separate legal entities
- Offer limited personal asset protection
- Are pass-through tax entities
- Have ongoing compliance requirements of the state
But there are some significant differences too. For instance, IRS only classifies business structures like sole proprietorships, Corporations (S Corp or C Corp) and partnerships for tax purposes. There is no separate tax structure known as “LLC tax structure”.
This means that an LLC’s taxation can only be as a sole proprietorship, Corporation or a partnership.
Taxation of LLC and S Corp
Business taxation is based on the net profit or loss of the business. Deductible expenses are subtracted from the sales and revenues for calculating the net profit or loss. Let us have a look at the different options an LLC has for taxation-
Taxation as a Disregarded Entity (Single-Member LLC)
If a single-member LLC’s taxation is as per a sole proprietorship, reporting of all the business income and expenses is through the personal income tax of the owner. The owner of a single-member LLC is self-employed and has to pay Medicare and Social Security taxes on the profits.
Taxation as a Partnership (Multi-Member LLC)
In case if an LLC is a multi-member LLC with a partnership tax structure, reporting of all the business income and expenses is through the personal income tax of the owners. However, as there are multiple owners in multi-member LLCs, the tax calculation is as per their ownership share.
For instance, if the net profit of a two-member LLC is $100,000 and your ownership percentage is 50%, you will pay taxes on $50,000.
Taxation as an S Corp (Single-Member and Multi-Member LLC)
When an LLC is an S Corp, it will pay a “reasonable salary” to the owner who is a working employee of the company. The remaining net income of the business after paying the owner’s salary passes through the personal income tax of the owner.
For instance, let us assume that the net profit of an S Corp is $20,000 after paying a $20,000 salary to the owner. In case of a single-member LLC, you will pay taxes on $40,000 as you are the single owner. The only benefit you can get here is avoiding self-employment taxes.
But if it is a multi-member LLC and you have 50% ownership in it, you will pay taxes on $30,000. $20,000 will be the salary from your LLC, and $10,000 is from your 50% share in the net profits of $20,000.
Who Pays More Taxes? LLCs or S Corps?
In most cases, S Corps pay more taxes in comparison to LLCs. This is because they have to pay state Corporate taxes and payroll taxes which may be applicable. Also, salaries which they give to the owner is also subject to disability tax, unemployment tax, Medicare and Social Security tax.
LLCs with single owners do not pay these taxes. But they also do not get the disability or unemployment benefits as LLCs do not pay anything to these funds.
So, Why LLCs Choose S Corp Tax Structure?
A large number of new businesses nowadays are run by independent contractors generally working with a single client. IRS generally prefers hiring of these contractors who function as consultants as employees and not independent contractors. This makes S Corp structure a better option in comparison to an LLC functioning as a sole proprietorship.
Also, LLCs have to pay estimated taxes on its net profits every quarter. A lot of owners are not very diligent with quarterly tax payments and get into serious problems with the IRS. As S Corps use payroll service, tax payments are taken automatically from the salary.
Can Every LLC Be an S Corp?
As per the S Corp definition of the IRS, every LLC does not qualify as an S Corp. Most of the single-member LLCs generally qualify. But there are a few reasons when they cannot. A few of these reasons are-
- Non-resident alien owner of the LLC
- Foreign LLC
- Business structure is as such that the LLC is a partnership or a Corporation
Also, multi-member LLCs which have more than 100 members do not qualify to be an S Corp.
How to Select Between LLC and S Corp?
To select between LLC and S Corp, try to evaluate the benefits of both the structures. For instance, see if the S Corp taxation can help you save more money as compared to a sole proprietorship or partnership taxation.
Focus on the reasonable salary for the owner as the IRS is very serious about the salary of the S Corp owner being reasonable. So, make sure that you do not select something that is artificially lower or higher than what you should receive.
Once you know the reasonable salary, see how much profit the business will be left with. If the leftover profit is not considerable, S Corp might not be the right choice for you. But if the gains are significantly higher after deducting your salary, S Corp taxation can help you save money.
But if you do select S Corp structure, note the tax return filing process will be more complicated. Also, if you are a single owner, you will also have to work on tax withholding.
There are only a few cases where an LLC can significantly benefit from electing the S Corp tax structure. Most businesses, as a result, prefer being a sole proprietorship or partnership. Some of the LLCs also go with the C Corp structure.
As a lot of intricacies are involved in this decision, consult a professional lawyer or accountant to help you make the right choice.