This blog addresses the biggest questions on many startup entrepreneur’s minds:
- What are the differences between an S corp vs LLC?
- Which type of business entity is best for a startup or small business
- What is the best business type for online business, real estate, construction, a restaurant, or other business…
If you are starting a business, the most common four choices for forming a legal entity are to continue with a sole proprietorship (no separate entity), a C Corp, an S Corp, or a limited liability company (LLC).
Since most businesses form as an LLC or an S-Corporation, we will focus on these two here. While LLCs and S-Corporations share many benefits and similarities, they also have several key differences that will impact your tax, administrative burden, and funding elections.
Here Are The Similarities
LLCs and S Corps have many things in common, including:
- Separate legal entities: Both LLCs and S corps require state filings to create and are separate legal entities. Both require state fees to be filed and for you to designate an agent to be responsible for communications from the state(s) you do business in.
- Limited liability protection: The owners of both LLCs and S corps are typically not responsible for business debts and liabilities, which means you can protect your personal assets like your cash, home, and investments by keeping them separate.
- Pass-through taxation: While both LLCs and S corps require the owners to account for their business financials, both entities pass through the profits and losses of the business to the owners and shareholders who report this income on their personal tax return. The S corp must file a business tax return, the LLCs only file returns if the LLC has more than one owner.
- Filings and state requirements: LLCs and S corps are both subject to formalities mandated by the state where you must pay regular fees, file annual reports, and keep your entity current.
The IRS imposes restrictions on ownership for S corporations but not for LLCs. Details include:
- Shareholder Types: S corporations must be owned by U.S. citizens / residents and NOT by other S corporations, C corporations, LLCs, partnerships, most trusts, or foreign entities.
- Shareholder Limits: LLCs can have an unlimited number of members while S corporations are limited to just 100 shareholders or owners and are allowed to have unlimited subsidiaries as well.
For these reasons, if you require equity investors for your business such as venture capitalists, family trusts, or formal investment groups, an S corporation will NOT be an option for you.
Formalities and Management
- S corp Formalities and management: The S corporation includes adopting bylaws, holding initial and annual director and shareholder meetings, maintaining corporate records and issuing stock to shareholders. S corps also have directors and officers, and the board of directors handle major decisions and corporate affairs, but the officers of the company (typically owners and managers), who run the daily operations of the business.
- LLC formalities and management: LLC formalities include adopting an operating agreement, issuing member shares and certificates, conducting annual member meetings and documenting all major company decisions. LLC owners can either manage the business themselves or hire managers to manage the LLC. There are fewer defined roles and a board of directors are not required.
Taxes & Other Differences
Some other important differences between LLCs and S corps include:
- Self Employment Taxes: Depending on your business’s income, the S corp may offer a lower tax burden than an LLC, since an S corp allows the owner to be treated as an employee and to be paid a reasonable salary. When done properly, an S corp owner pays 15.3% self employment (called FICA) taxes only on the owner’s reasonable salary, and the rest of the business’s net income may be excluded from this tax (and taxed at ordinary rates). With an LLC, the owner pays self employment tax on substantially ALL earnings of the business, whether distributed to the owners or not, which can lead to LLC members paying 15.3% FICA on all income generated from the LLC.
- Ownership Transferability: One can typically transfer S corporation stock free (see ownership restrictions above), while LLC membership interests must typically be approved prior to transfer.
- Entity Existence: S corporations live in perpetuity (no end of life date), while most states require LLCs to have a date of dissolution in the LLC formation documents and records. This mean that special events in your operating agreement such as member death or other event can force the LLC to dissolve.
Which entity is right for you?
Our partners at incorporate.com can help you determine the best legal entity structure and tax election for your business.