If you operate a business in the United States, your company’s success depends on choosing the right type of business. The structure that a business owner uses to incorporate is one of the first and most important choices they must make. LLC vs. S Corp—they both have different requirements and tax implications.
In this article, I’ll be going over both LLCs and S Corps to help you determine which model is best for your business.
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LLC vs. S Corp
There are a variety of business entity types to choose from when starting a business. Popular choices include limited liability companies (LLCs) and S corporations (S Corps), which differ in many ways, including taxes and management structures.
A company may occasionally be both an LLC and an S Corp. Before deciding which type of business is best for your company, here is everything you need to know about these types of businesses and their differences.
All income must be taxed as self-employment by LLC owners. If S Corp owners pay themselves a “reasonable salary,” they may pay less of this tax. S corporations can only have 100 shareholders, whereas LLCs can have any number of members.
Keep reading, as this article is for business owners and entrepreneurs who are deciding between an LLC and an S corporation for their company.
What’s an LLC?
The business structure known as a limited liability company (LLC) safeguards the personal assets of the company’s owners, or “members.” Suppose the company is sued by a debt collector or involved in a legal dispute. The plaintiff or creditor can only pursue the business’s assets in that scenario, not the members’ personal assets.
Because it is a pass-through entity, the LLC’s profits “pass through” the business to the LLC members if it is taxed as a sole proprietorship. Instead of submitting a corporate tax return, they can report the profits on their individual returns. The members of the LLC are liable for self-employment tax on their income.
Alternately, an LLC may be taxed like an S corporation, which means that each member must receive a salary that is reasonable. The LLC deducts payroll taxes and includes the owner’s salary as a business expense. Dividends are paid out from the remaining profits of the business.
What’s An S Corp?
Known as an S corporation, S Corp, or S subchapter, these entities inform the IRS that your company should be taxed as a partnership. Additionally, it prevents your company from being subject to corporate-level double taxation.
Keep in mind that your company must first register as a C corporation or an LLC before it can become an S corp.
Shareholders are the business owners in an S corporation. As the owner, you are considered an employee of the company and are required to compensate yourself fairly. The shareholder pays taxes on the profits, losses, deductions, and credits of an S corp.
Your company can have one to a hundred shareholders to be considered an S corporation. Additionally, your company must be based in the U.S., and you must file tax returns as an American corporation.
What Distinguishes an LLC from an S Corp?
Small business owners frequently choose to form an LLC rather than a corporation due to its greater freedom. However, it’s essential to be aware of the distinctions between LLCs and S corporations prior to making this crucial decision.
Self-employment taxes, such as Medicare and Social Security taxes, must be paid directly to the IRS by LLC members.
According to the Internal Revenue Service (IRS), these tax rates change annually, but in 2022, the self-employment income tax rate was 12.4% for Medicare and 2.9% for Social Security. Any revenue generated by an LLC is regarded as taxable revenue.
Shareholders in an S Corp receive a salary, and the company pays their payroll taxes, which can be deducted as a business expense from the taxable income of the business. Dividends, which are paid to shareholders at a lower tax rate than regular income if there are any leftover profits from the business, are used to pay out dividends.
LLC vs. S Corp: Stock, Subsidiary Restrictions, and Shareholder Structure
S corporations can’t have more than 100 shareholders, but LLCs can have any number of members they want. Non-U.S. citizens can’t be shareholders in S corporations, but they can be members in LLCs.
Additionally, LLCs and S corporations have distinct subsidiary restrictions: S corporations are prohibited from establishing subsidiaries, whereas LLCs are permitted to do so without restriction.
Lastly, LLCs cannot issue stock, whereas S corporations can, but only one class of stock can be issued.
Which is Better for Entrepreneurs?
In all honesty, it varies.
A good way to start is to file to become an LLC because this structure protects against liability and allows for tax deductions. However, if your business reaches a point where it’s no longer just a startup, changing to an S corporation might be financially beneficial. because the self-employment tax rises with LLC income.
Across all businesses, sole ownerships and organizations might be best off excess as LLCs. This is because LLCs are straightforward enough that adding a corporate status might overly complicate matters.
If you do not intend to sell stock or seek funding from venture capitalists or angel investors, an LLC may still be the best option for your company as it expands. Otherwise, as is frequently the case for any large, complex business, an S Corp might be preferable.
Is It Possible to Switch From an LLC to an S Corp?
Yes—it’s possible to switch between LLCs and S corporations. In fact, your company can be both at the same time; The two are not incompatible.
Your state-level LLC status remains unaffected by filing for federal S Corp status. After you decide to file your taxes under this category, you can even get rid of your S Corp status. However, more paperwork is required for this, so try to make decisions you won’t regret.
The Advantages of Taxing Your LLC as an S Corp
- Your salary and payroll taxes are paid for by the business—As with a regular LLC, you would pay self-employment taxes on the business’s gross income, so this could save you money on taxes.
- Dividends are given to shareholders because of additional earnings.
- Because dividends are taxed at a lower rate than income, this could also help you save money.
The Disadvantages of Taxing Your LLC as an S Corp
- A salary cap exists—Owner-employee compensation must be established at a reasonable level.
- Limitations exist—You can only have one stock class and 100 shareholders.
- Restrictions for shareholders—Shareholders cannot claim employee health insurance as a tax-free benefit like they could with a C Corp because they own more than 2% of the company’s stock.
Starting your LLC vs. S Corp Journey
Many entrepreneurs start new businesses as LLCs to protect their personal assets from legal liability. However, to reap the financial benefits of filing as an S Corp as your business expands, consult your CPA or tax business professional, as laws and implications change based on the state where you reside.
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