S Corp vs. LLC: Key Differences, Tax Impacts, and How to Choose

Key takeaways

• Limited liability companies and S corporations offer different taxation benefits and management structures.
• Both LLCs and S corporations offer liability protection that safeguards owners’ personal assets from business debts and legal issues. 
• LLCs have more management flexibility than S corporations and fewer compliance requirements.
• Consider your business needs, assess your financial situation, and consult with legal or tax professionals when deciding which legal entity/tax classification best suits your business's risk level, asset protection, and management needs.

What is an LLC?

A limited liability company (LLC) is a legal business structure that can protect small business owners from personal liability in business obligations. This is a key feature of LLCs and sets them apart from sole proprietorships and partnerships, which don’t have limited liability protection. Owners of LLCs are known as members. Limited liability companies can have one owner (single-member LLC) or more than one owner (multiple-member LLC). 

Here are the main elements of an LLC: 

• A formal business structure that must register with the state
• Generally good protection from personal liability for business debts
• Flexible ownership and few formal requirements
• Default pass-through tax classification

LLC taxation

By default, LLCs are taxed as pass-through entities, where profits and losses pass through to the owners’ personal tax returns. Standard taxation for LLCs mirrors sole proprietorships (for single-member LLCs) and partnerships (for multiple-member LLCs). The benefit of pass-through taxation is that it avoids the double taxation experienced by C corporations, wherein both the corporation and its shareholders are taxed). However, owners of pass-through entities must pay a 15.3% self-employment tax on all net profits.

Single- and multiple-member LLCs can also elect to be taxed as C corporations or S corporations if they meet eligibility requirements.

LLC flexibility and formalities

Overall, an LLC is more flexible than a corporation in organization, leadership decisions, and profit distribution, all of which are typically laid out in an operating agreement. An operating agreement is an internal document used to clearly lay out the rules for how your company will be run. It’s not required by state law but is helpful for preventing disputes.

LLCs also have fewer compliance requirements than corporations. For instance, LLCs do not have to write bylaws or adhere to other corporate management requirements. They aren’t required to have mandatory annual meetings or take meeting minutes, plus, there are fewer requirements for recordkeeping. However, most LLCs must submit annual reports to the state agency that oversees business formation and pay a franchise tax in some states. 

LLC ownership and management

LLCs can choose from two management models:

• Member-managed: LLC members (owners) manage the various aspects of the business
• Manager-managed: LLC members hire one or more managers to manage the business

For LLC members that want to play an active role, member-managed is the best choice. But if the members lack management expertise or are predominantly serving as investors, it may be beneficial to opt for a manager-managed LLC structure. 

LLC ownership is also flexible. An LLC can have unlimited members worldwide, and these owners can also be another corporate entity. There are no restrictions on classification or nationality.

LLC benefits: The bottom line

An LLC protects owners’ personal assets while keeping operations simple. Here is an overview of the main benefits of an LLC:

• Limited liability protection for members. This means that if the business owes money to a creditor, the owner's personal assets will not be used to pay off that debt. 
• Flexible ownership and management. There are no limits on the number of LLC members, and they don’t have to be U.S. residents. LLCs can be member- or manager-managed.
• Simple setup and few compliance requirements. LLCs typically have less formation paperwork and fewer ongoing legal obligations compared to corporations.
• Flexible profit allocation. LLC can choose how profits are distributed to members. For example, profits can be allocated based on work contributions instead of by ownership percentage.

What is an S corporation?

An S corporation is a tax classification for a qualifying corporation or LLC that can protect small business owners' assets from double taxation. It gets its name from its definition in subchapter S of the Internal Revenue Code. An S corp utilizes pass-through taxation, meaning an owner claims a share of company profits on their return when they file taxes. This tax classification also helps shareholders avoid double taxation at the federal level by passing income directly to their personal income tax returns.

According to the Internal Revenue Service, you must meet the following requirements to elect S corp status:

• Gain consent from LLC members to convert to S corp election
• Be a U.S. business
• Have no more than 100 shareholders (who are not corporations, partnerships, or non-resident aliens)
• Have only one class of stock
• Can not be a financial institution, insurance company, or other ineligible corporation

S corp taxation

Business owners that elect S corp taxation are essentially treated as company employees, meaning that they must pay themselves a reasonable salary for their work. They'll pay federal income taxes and state income taxes, Medicare, and Social Security tax on that salary. Owners receive additional profits as distributions, which aren't subject to Medicare and personal income tax or Social Security taxes.

The major advantage of an S corporation is avoiding having to pay self-employment taxes on a portion of the owner's income. In an S corp, only owner-employee salaries are subject to taxes for Social Security and Medicare. Any additional profits distributed to shareholders are not subject to these taxes, which can result in significant tax savings. This contrasts with an LLC, where owners may be subject to self-employment tax on all net earnings from the business.

S corp formalities and structure

The management for an S corp is a bit more complex than for an LLC. It requires a formal structure that includes a board of directors and corporate officers. The number of directors on the board varies according to state law, but most states require at least one director. Officers are appointed by the S corp owner to manage different aspects of the business. However, it’s just fine for one person to hold owner, director, and officer roles, in the case of one entrepreneur who elected S corp taxation.

Most states mandate that corporations, including S corporations, conduct annual shareholder and board meetings and document the information through meeting minutes, which act as legal proof of any formal changes to the business and that you’re serving in the best interest of the shareholders. This requires more recordkeeping than an LLC. 

Additionally, every S corp must create corporate bylaws that essentially dictate business operations and procedures.

S corp ownership restrictions

An S corp must be a U.S. business owned by U.S. citizens or residents and cannot have more than 100 shareholders. Beyond individuals, trusts and estates can also be owners of S corporations.

Like a C corporation, an S corp can issue stock. They can only issue common stock with shareholder voting rights.

S corp benefits: The bottom line

There are several advantages of choosing an S corp election: 

• Pass-through taxation. S corporations are not subject to corporate income tax, meaning that they're not double taxed. 
• Potential to reduce tax burden. S corp owners can split their compensation into salary + distributions, helping to reduce taxable income.
• Credibility and investor attraction. A formal corporation status and ability to issue stock can appeal to banks and investors.
• Personal liability protection. S corp owners’ and shareholders’ personal assets, such as their personal bank accounts or their home, cannot be taken in the case of debts or litigation.