Entrepreneurs who are interested in starting a business must first decide what type of business entity the company will be. One of the options is a limited liability company (LLC). Often mentioned alongside an LLC is an S Corp (or S Subchapter), but an S Corp isn’t a business entity it’s a tax status.
It sounds confusing, but a business owner can set up an LLC and elect to pay taxes as an S Corp. This guide should answer many questions about the differences between an LLC vs S Corp.
What is an LLC?
An LLC is a type of business that’s registered with the state and gives the owner or owners personal liability protection. It keeps the owner’s personal assets separate from that of the business. If the company finds itself in financial trouble or is sued, the owner’s personal assets are safeguarded. Only what’s invested in the business can be used to bail it out.
For tax purposes, an LLC owner pays taxes on the business profits through his or her personal tax returns, which is called pass-through taxation. The company itself is not taxed, just the owner’s income. (Some business entities, like a corporation, face double taxation where the company and the owner are both taxed on income earned).
An LLC can be owned and operated in many different ways. From a single-member LLC, which means the company has just one owner, to a company owned and managed by different members, the company structure is flexible.
What is an S Corp?
An S Corp, also known as an S Corporation, is an IRS tax designation not a business entity type like an LLC, sole proprietorship, or corporation. A company can set up an LLC and elect to file taxes as an S Corp.
The S Corp tax status exempts companies from paying corporate income taxes and instead has the owner pay taxes on income earned on his or her personal income tax return. While this sounds exactly like the taxation of an LLC, there are some differences.
With an S Corp, owners earn a reasonable salary, which faces both self-employment tax (Social Security taxes and Medicare taxes) and income tax. The self-employment tax rate changes each year, but in 2020, the tax rate was 12.4% for Social Security and 2.4% for Medicare. Income is taxed based on the amount of money earned.
Any additional business income that’s doled out beyond the set salary is considered a distribution. Distributions are taxed at a lower rate and aren’t subject to self-employment taxes, which adds up to big tax advantages for companies that elect an S Corp tax status.
If a company is taxed as an LLC, all earnings are subject to both self-employment tax and income tax.
Benefits of an LLC
A limited liability company offers an owner personal liability protection, which protects the owner’s personal assets. Any financial or legal problems that the business faces won’t impact the owner’s home, car, or personal investments. For many, this is one of the biggest benefits to setting up an LLC.
Creating an LLC gives customers, vendors, and investors, security knowing that the company is registered with the state.
Ownership and management flexibility
Many company owners opt for this type of entity because of its flexibility in corporate ownership and management. An LLC can have many owners and be managed by them as well. The corporate structure is more rigid in different types of businesses like a corporation, where a board of directors must oversee the company.
Benefits of an S Corp
Self-employment tax savings
A company that’s taxed as an S Corp pays self-employment taxes on a set salary but doesn’t pay them on any earnings that are above that. For example, if an owner’s salary is set at $30,000, this portion of the earnings is taxable income and faces income tax and self-employment tax. Any income that’s made over that is considered a distribution, which self-employment taxes are not taken out of.
An S Corp can contribute up to 25% of an employee’s salary to a SEP IRA. An S Corp that’s owned by a single individual or a married couple can also set up a Solo 401(k) and defer money up to $19,000 per person into the account.
Tax savings from health insurance
Company owners often pay for their own healthcare out of pocket, but if the company is an S Corp, the amount paid is often deductible and the premiums are exempt from self-employment taxes.
Many of the benefits of an S Corp focus on financial savings, so it’s a good idea to discuss this tax classification with an accountant to see if it’s best for your company.
How to form an LLC
Forming an LLC is different than forming an S Corp. To form an LLC as a business structure, here’s what you need to do:
1. Pick a name
The company must have a name before an LLC can be filed. The name can’t already be in use, so the business owner must check name availability with the secretary of state’s website. Most states have a search tool on the website to make this process fairly easy.
Most states require a business name to have “Limited Liability Company” or “LLC” in the name as well.
2. Pick a registered agent
Aside from picking a company name, the business owner must pick a registered agent. A registered agent is a person or company that accepts important documents on behalf of your business. These documents could be sensitive in nature, like tax notices or legal paperwork. For this reason, it’s important to carefully select the person or company that is put into this role.
Most states do allow the business owner to be the company’s registered agent. A registered agent service can also be hired to fill this role.
3. File Articles of Organization
To officially launch an LLC in any state, LLC formation documents must be filed with the state. In most states, the documents are called Articles of Organization, which can be found and filed online through the secretary of state website.
The form will ask for the company name and address, the registered agent’s name and address, the names of managers, and the start date of the company. Once submitted, the state will approve the document and an LLC is officially started in the state.
Once a year, most states require LLCs to file an annual report to remain in good standing with the state.
Expect a filing fee to coincide with both the Articles of Organization and the annual report. Fees vary by state.
How to form an S Corp
Wondering how to set up an S Corp? Here’s how:
1. Register your business
An S Corp is a tax entity, so the company must be registered as another type of business. A small business can be set up as an LLC, for example, but it must have a business structure. (To officially set up an LLC, review the instructions above).
2. See if the business qualifies as an S Corp
Not all businesses are eligible for the S Corp tax status. You can select this status if the business:
- Is set up in the U.S.
- Has shareholders that are U.S. citizens or residents
- Has 100 or fewer shareholders
- Has one class of stock (if stock is issued)
- Is not a financial institution, insurance company, or a domestic international sales corporation, which are all banned from this tax status
3. File tax forms
If a business owner meets the criteria above and wants to move forward as an S Corp, the owner must file IRS Form 2553.
To fill out this form, you’ll need the business name, federal identification number (EIN), business address, date and place of incorporation, and the name, address, and ownership percentages of each shareholder. This is the federal form that the Internal Revenue Service needs to recognize a startup or small business as an S Corp, but the state may have a similar form that must be submitted as well.
It’s best to speak with a CPA about S Corporation status to make sure all proper documents are filed on time and with the right agencies.
What are the disadvantages of becoming an S Corp?
An S Corp tends to be scrutinized by the IRS more than others. Since there are certain tax breaks afforded to these types of businesses, the IRS keeps a close watch on what a company deems a “reasonable salary” versus what’s taken as a distribution.
There are additional tax forms that must be filled out as well, so taxes may be something that an accountant handles instead of filing them on your own.
Do all states recognize S Corporations?
No. There are a handful of states like New Hampshire and Tennessee that don’t recognize S Corps. However, a company will still receive federal tax benefits from the IRS, but won’t receive any state tax breaks.
Can an S Corp or an LLC be set up without an attorney or an accountant?
Yes. Both an LLC and an S Corp can be set up without help, but it’s always a good idea to consult both before making decisions. Many people do involve both a lawyer and a CPA in the process.
Why is a registered agent necessary for an LLC?
Every state requires a business to have a registered agent. Why? The registered agent serves as a point of contact. If the state needs to deliver important notices like tax documents or service of process papers that are served during a lawsuit, they must be placed in the hands of a person closely tied to the company.