If limiting personal liability is important to your business, you need to decide whether you want to operate as a corporation or a limited liability company (LLC), and whether you want to make an S corporation (S Corp) election. You first need to know: What is an S Corp

What Is an S Corporation?

A basic S Corporation definition is: A corporation that files under Chapter 1, Subchapter S, of the Internal Revenue Code. An S Corp election will be taxed by the federal government in the same manner as a sole proprietorship or general partnership. S Corp taxes to the IRS are less than taxes on a corporation that does not become an S Corp.

Although there can be an LLC S Corp, this option does not give an advantage to most small businesses, but it will be discussed more below. We will first examine the difference between LLC and S Corp entities, where the LLC has not elected S Corp status.

Corporations and LLCs

In many ways corporations and LLCs are similar, but have different terminology. Owners of a corporation are called shareholders, those who manage the operations are called officers, and the documents that form the corporation are articles of incorporation and bylaws. Profits, called dividends, are distributed to shareholders according the number of shares each owns.

With an LLC, owners are called members, those who manage operations are managers, and an operating agreement forms the LLC. Profits are passed through to the members, similar to a sole proprietorship or partnership.

Federal taxation is a big consideration, but both corporations and LLCs are formed under state law. When a corporation is first formed, it is called a C Corporation (or C Corp) for IRS purposes. A C Corp can change to an S Corp by filing IRS Form 2553.  

Generally, large corporations, or those with a lot of start-up capital and large ambition, do not make the S Corp election. This is because S corporation status cannot be used if the corporation:

• Will have more than 100 shareholders, or
• Will issue more than one class of stock, or
• Will offer shares of stock to the general public.

A corporation exists perpetually. Some states require the LLCs to have a dissolution date, and some require dissolution in the event of the death, bankruptcy, or withdrawal of a member. 

Determining the Best Business Structure

The main factors usually considered when deciding upon the form of a business are:

• Limitation of personal liability (corporations and LLCs limit personal liability)
• Taxes
• Cost and complexity of formation and operation
• Profit-sharing arrangements
• Transferability of ownership interests

To determine whether an LLC or S Corp is best for your business, you will need to evaluate all of these matters, probably with the advice of tax and legal advisors, to determine which is best for you. For most business owners, neither an S Corp nor an LLC will be ideal. It is usually a process of weighing the pros and cons of each type of business, and deciding which best meets your most important needs.

Taxes

The manner in which businesses are taxed varies depending upon the type of business entity, and state laws.

Federal Tax. For federal tax purposes, C Corporation profits are taxed, and are reported on the corporation tax return. Any after-tax profits that are distributed to the shareholders as dividends are taxed again, and are reported by the shareholders on their personal tax returns. This “double taxation” can be avoided by electing S Corp status for your corporation. With an S Corp, the profits (or losses) are divided among, and only taxed to, the shareholders.  

With a single-member LLC, that member reports the profit or loss on a Schedule C form. A multi-member LLC files a Form 1065 partnership tax return, and each member reports his or her share on their personal tax return. Either way, LLC profits are only taxed to the members. 

Self-employment Tax. Whereas corporate dividends are generally not subject to the self-employment tax, all profits from an LLC are considered income subject to self-employment tax.

Owners as Employees. An owner must be paid “reasonable compensation” for services as an employee. Paying too low of a salary can result in the IRS reclassifying some dividends as salary, requiring the payment of additional taxes, interest, and penalties. Also, while some employee benefits can be deducted as business expenses, things like medical and life insurance can become taxable income if the employee owns two percent or more of the total shares. 

State Tax. Many states also pass profits (and losses) through to the owners of S Corporations and LLCs. However, a few states engage in double taxation of corporations (even S Corps), and some states tax LLCs.  

Formation and Operation

State laws govern the formation and ongoing operation of corporations and LLCs. Generally, there are more requirements for a corporation than for an LLC. Corporations are required to issue stock, adopt by-laws, hold annual director and shareholder meetings, keep minutes of meetings, issue written corporate resolutions for significant decisions, and file annual reports with the state government. Failure to do these things can result in the loss of personal liability protection and have serious tax consequences. LLCs are not legally required to do these things (although it is a good idea to hold member meetings and keep adequate records).

Ownership and Profit Sharing

Ownership.  According the IRS, a corporation that elects S Corp status may not:

• Have more than 100 shareholders.
• Have shareholders who are not U.S. citizens or residents.
• Be owned by a C Corporation, other S Corporations, LLCs, partnerships, or various trusts.

None of these restrictions apply to LLCs.

Ownership Transfer. Stock in an S Corp is easily transferred, provided the ownership restrictions mentioned above are followed. With an LLC, a member’s interest is more difficult to transfer. It often requires the agreement of the other members.

Profit Sharing. S Corp shareholders pay taxes based upon each person’s percentage of stock ownership. For example, if 75% of the stock is owned by shareholder A and 25% by shareholder B, 75% of the corporate profits are passed through to A and 25% to B. An LLC would allow them to be more flexible, and divide the profits in any manner they can agree upon.

LLC as S Corp

It is not always a matter of S Corp vs. LLC, since an LLC can also register as an S Corp. This is usually done to reduce self-employment taxes. All profits of a regular LLC are passed through to the members, and are subject to self-employment tax. By registering as an S Corp, the LLC profits pass through to members as dividends, which are not subject to the self-employment tax. An S Corp LLC gets the tax benefits of a corporation, but without the formation and operating requirements, and without the ownership limitations.

The LLC vs. S Corp analysis is not easy. It requires a full understanding of complex federal and state tax laws, which usually means consulting a professional tax advisor. For most small businesses an LLC is the easiest way to begin. As your business grows, you can always convert to a corporation or register your LLC as an S Corp to gain the advantages of those forms of organization.

When you are ready to start a business, LegalZoom can help you get the paperwork you need. By answering a few questions online, we can help you complete the formation paperwork and file it with the secretary of state. We help you speak with an independent attorney about your business, and they’ll help you decide if forming an S corp is right for you.