So, you’ve decided you want to move beyond doing business as a sole proprietor and you’re starting to think about what business structure is right for you. This post lays out the differences between LLCs and S-Corporations to help you make the right choice for your business.
What is an LLC?
An LLC is a Limited Liability Company. It is formed by filing Articles of Organization with your state. Owners of an LLC are called “members”. An LLC with one member is called a single-member LLC. An LLC with multiple members is called, you guessed it, a multi-member LLC. Generally, members can be either individuals or other businesses. An LLC can either be member managed (where it’s run by the members) or manager managed (where it’s run by managers). You can learn more about LLCs in this post.
What is an S-Corp?
S-Corp stands for S-Corporation. It’s like a regular corporation when it’s created, but makes an election with the IRS to receive special tax treatment. You may have heard of the “double taxation” of corporations. S-Corps were created to avoid double tax for small businesses. Just like a C-Corp, an S-Corp has shareholders and issues stock to the owners of the company. However, there are strict rules before a company can receive S-Corp status, including: (1) must be a domestic corporation; (2) shareholders can only be citizen residents of the US or certain trusts/estates and may not be partnerships, LLCs, or other corporations; (3) must have 100 or less shareholders; and (4) must have only one class of stock.
To determine which business structure is right for you, consider the following:
LLCs are formed by filing Articles of Organization in a particular state. In most states, this is a fairly straightforward one-page document and can be filed online. Although, a few states (Arizona, Nebraska, New York, and possibly others ) have an additional requirement of publishing notice of your intent to form an LLC. An LLC is an entity separate from its members.
S-Corps are incorporated by filing Articles of Incorporation in a particular state. Generally, Articles of Incorporation are more detailed than Articles of Organization, though still often just one page. Filing the Articles of Incorporation creates a corporation. To receive S-Corp status, the company must then file Form 2553, signed by all shareholders, to elect S-Corp status from the IRS.
2. Liability Protection
Both LLCs and S-Corps provide limited liability protection to the owners. This means the owners are not personally liable for the claims, debts, and liabilities of a company. One of the biggest reasons people form a business entity outside of a sole proprietorship or partnership is the limited liability protection offered.
However, both LLCs and S-Corps are at risk for “piercing the corporate veil”. Piercing the corporate veil is when owners do become liable for the claims, debts, etc. of a company, because the company was essentially a “veil” shielding an individual’s personal assets. Most often this happens when the owners don’t observe the formalities of owning a business—commingling funds, using business assets for personal use, not having proper documentation for the business. Generally speaking, it is probably less likely to pierce the corporate veil of an S-Corp since the requirements for managing a corporation are more strict than an LLC.
3. Management & Recordkeeping
LLCs can elect to managed by its members or managers. Member-managed means it is run by the members. Manager-managed means managers are either elected or appointed, and the managers make most decisions for running the business. In most, if not all states, an annual report is required to be filed with the state. Other than the annual report, after filing Articles of Organization, usually nothing additional is required of an LLC. But, it is strongly recommended an LLC create an Operating Agreement (yes, even if it’s a single-member LLC) and document decisions made for the company.
S-Corps are run and managed by directors and officers. Again, an annual report is usually required to be filed with the state. However, unlike LLCs, S-Corps must follow formalities to keep its corporation status. This includes adopting by-laws, issuing stock, holding initial & annual director/shareholder meetings, and keeping minutes of those meetings.
Unless an LLC makes a special election with the IRS, it is taxed like a sole proprietorship or partnership. An LLC’s profits are passed down to its members and reported as income to those members. So, the profits are taxed at the individual level. One downside of LLC taxation, is an LLC’s members are generally required to pay self-employment taxes to cover the cost of Medicare & Social Security, since an LLC cannot generally pay a salary to its members.
S-Corps receive more favorable tax treatment than C-Corps, because no corporate tax return is required. Instead, an S-Corp is required to file Form 1120S. Shareholders who work for the S-Corp must be paid a reasonable salary (based on industry standards) and are taxed on that as income. Any other compensation a shareholder receives is a distribution and is generally taxed at a lower rate. Since an S-Corp will be responsible for Medicare and Social Security, its shareholders do not pay self-employment tax.
For investors, C-Corps are the preferred business structure to invest in. S-Corps are generally preferred to LLCs. Since LLCs don’t have stock, investors become members in the company. Membership interests in an LLC are taxed as personal income, so for some investors this would increase their tax liability. In an S-Corp, investors receive stock in the company and any money they receive from the company is taxed as a distribution at a lower rate. Also, S-Corps seem more permanent than LLCs, since in some instances an LLC automatically dissolves upon the death or some other action of one of its members. That being said, if you foresee the need to have investors in your company, you may want to skip S-Corp and LLC altogether and go with a C-Corp.
So, which is right for you?
S-Corps and LLCs are the most common business structure for small businesses. There are some similarities between the two, like the limited liability protection provided, but the differences in formation, formalities required, tax treatment, and the ability to attract investors can help you choose which structure is most appropriate for your business. If you have specific questions, you should contact an attorney licensed to practice in your state. If you decided an LLC is the right business structure for you, check out the guide to DIYing your LLC.
Disclaimer: This site, and all information contained herein or through communication with me, is intended as legal information only. I am an attorney, but I am not your attorney, so nothing on this site, nor any communication with me, shall create an attorney-client relationship. I am not liable for damages or losses based on any action taken, or inaction, based on the information contained on this site. All areas of the law are fact specific and there is no substitute for legal advice from an attorney licensed in your jurisdiction who is familiar with the specific facts and circumstances of your situation.