Among the many decisions you’ll need to make when starting a business, choosing the right entity that will define the legal structure of your business is an important one. The two most popular options for new entrepreneurs are Limited Liability Companies (LLCs) and S Corporations (S Corps).
While both entities offer limited liability protection to owners, there are some key differences between them. In this blog post, we’ll explore the differences between LLCs vs S Corps, highlighting their unique features and advantages, and help you make an informed decision for your business.
LLC vs S Corp: The Key Differences
Before we dive into the key differences, it’s important to note that if you are already established as one of these entities but find the other may be more advantageous, you can make the switch, but there are procedures you have to follow.
For example, if you are switching from an LLC vs an S Corp, you have to fill out FORM 2553. This form will is essentially an election. It is due by March 15 to the IRS and they will send back an approval letter noting the S-election.
If you plan to move from one entity to another, consult with your financial partners to ensure it’s the best move and guarantee you complete all of the necessary steps throughout the process.
Taxation
One of the commonalities of LLCs and S-corps is pass-through entity tax. They both offer it, which 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 sets them apart from C-corps in that they avoid double taxation.
However, even though LLCs and S-corps are both pass-through tax entities, they follow very different federal income tax rules.
LLCs provide owners with the flexibility to choose how they want to be taxed. By default, they are taxed like sole proprietorships or partnerships, with the profits and losses passed through to the owners’ personal tax returns. They also pay self-employment taxes, which include Social Security and Medicare taxes. However, LLCs can also elect to be taxed as an S corporation, which can offer additional tax benefits.
Like an LLC, an S corporation’s profits and losses still pass through to the owners’ personal tax returns. However, the owners of an S corporation are considered employees of the company, and they must receive reasonable compensation for their services. This means that they must pay Social Security and Medicare taxes on their salary or wages, just like any other employee. Any remaining profits are distributed to the owners as dividends, which are not subject to Social Security and Medicare taxes.
For a detailed calculation and explanation of the differences in payroll taxes between the two, check out this video.
Ownership and Management
When it comes to ownership and management, LLCs and S-corps have some notable differences that can impact how you structure your business.
LLCs are versatile in that they can be owned by a single person or multiple people, who are known as members. And there are no limits on how many members an LLC can have.
S Corps, on the other hand, are owned by shareholders, but they’re a bit more restrictive. They can only have up to 100 shareholders who must be US citizens or residents, and only one class of stock is allowed. S-corps also require a board of directors to oversee the company’s management.
Formalities and Paperwork
When it comes to formalities and paperwork, LLCs require less than S-corps. Not only are LLCs generally less formal, but they also require less paperwork.
S-corps have to hold annual meetings and keep detailed records of their activities through meeting minutes. There’s also added administrative work and costs that come with filing annual reports with the state and tax returns with the IRS.
Liability Protection
Limited liability protection is one of the biggest benefits of choosing an LLC or S-corp structure for your business. This means that as an owner, your personal assets are shielded from the:
- Company’s losses
- Debts
- Any lawsuits
Regardless if you are a member of an LLC or a shareholder of an S-corp, your personal assets (such as your home or car) are typically protected. However, it’s important to note that shareholders can still be held liable for any unlawful acts they commit or if they fail to follow legal or ethical guidelines.
Overall, whether you choose an LLC or S-corp structure, limited liability protection is a key benefit that can give you peace of mind and protect your personal assets in case of unexpected events.
Profit Distribution
LLCs generally have more flexibility in how they distribute profits among their owners. The profits can be distributed according to the owner’s ownership percentage or according to a different arrangement agreed upon by the owners.
S-corps, on the other hand, must distribute profits to shareholders according to their ownership percentage, which can limit the flexibility of profit distribution. Additionally, S-corps cannot have different classes of stock, which can restrict the ability to offer certain types of equity incentives. They are only able to issue one class of stock, with each share representing an equal ownership stake.
Selecting the Right Entity
The entity you choose will affect your taxes, ownership structure, profit distribution, and more. That’s why it’s important to work with an accountant who can help you make the right decision for your business.
An experienced accountant can help you weigh the pros and cons of each entity type and choose the one that makes sense for your specific needs. They can also help you with the paperwork and filings required to set up and maintain your chosen entity.
Our experienced team of accountants at Pasquesi Partners can help you assess your business’s unique circumstances, goals, and tax situation to determine which entity type is the most appropriate for your needs. Contact us today to learn more about how we can assist you in selecting the right entity for your business.