S corporations and limited liability companies (LLCs) are often a source of confusion since they refer to different aspects of a business but are often discussed together. An LLC is a type of business entity, while an S corp. is a tax classification.
You can form an LLC and choose to be taxed as an S corp., but your business can also operate under the default taxation system for LLCs.
What Is an LLC?
A limited liability company is a popular choice for small business owners who want a more formal business structure than a sole proprietorship or partnership.
An LLC helps the business owners limit their liability for business obligations. Compared to a corporation, an LLC is flexible in the way the business is run and profits are distributed. In some states, LLCs have less strict record-keeping requirements than corporations.
LLCs are also flexible in their tax status.
By default, an LLC is taxed in the same way as a sole proprietorship or partnership. If you're an LLC owner who works in the business, the Internal Revenue Service (IRS) considers you self-employed. You'll file an LLC tax return on Schedule C of your personal return, and you'll pay self-employment taxes and income taxes on your share of the company's profits.
But LLCs can also choose to be taxed as a corporation. Some LLC owners save money by electing S corp. tax status.
What Is an S Corp.?
An S corporation isn't a type of business, it's a tax classification. Unlike traditional C corporations, an S corp. doesn't pay corporate income tax. Instead, the company's profits pass through to the owners.
The owners each report their share of the S corp. pass-through profits on their personal income tax returns. Both LLCs and corporations can elect S corp. taxation.
For tax purposes, a major difference between an LLC and an S corp. is that owners who work in an S corp. can be company employees, while LLC owners are considered self-employed. It should be noted that:
- Self-employed LLC owners pay income tax and self-employment (Medicare and Social Security) taxes on their entire share of the company profits.
- S corp. owner-employees must pay themselves a reasonable salary for the work they do. They'll pay income, Medicare, and Social Security taxes on that salary. Additional profits are allocated to the owners as distributions that aren't subject to Medicare and Social Security taxes.
The upshot is that if your LLC makes a profit after the owners have been paid a reasonable salary, you might save money on taxes by electing S corporation taxation. Other benefits of an S corp. might include the ability to contribute more money to retirement plans and to position your company for growth.
S Corp. Requirements
Not all businesses are eligible to be taxed as S corporations. You must meet the following requirements:
- You must be a U.S. business
- You can't have more than 100 owners
- Owners can be individuals and certain types of trusts and estates, but S corps. cannot be owned by partnerships, corporations, or non-resident aliens
- There can only be one class of stock
S Corp. Disadvantages
For most small businesses, there are few drawbacks to S corporation taxation. Depending on your business, switching to an S corp. may mean filing additional tax forms or setting up a payroll system. If your company isn't making much money, these additional hassles may outweigh the benefits.
An S corp. may also not be the right choice if you plan to bring in outside investors or retain profits in the company bank account. In these situations, a C corporation is sometimes a better option.
How to File as an S Corporation
If your business qualifies, setting up an S corp. is simple. You'll need to form an LLC or corporation if you haven't already. Then you simply file a form with the IRS electing S corporation taxation.
Choosing the right tax classification can save your company money, but the decision isn't always clear-cut. You'll need to consider your company's profitability, your potential taxes, and your plans for growth and retirement. A lawyer can help you sort through these issues and explain how to create an LLC and how much an LLC costs in your state