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After starting your business, you may need to decide on the right legal and tax structure. Two popular options for small business owners are limited liability companies (LLCs) and S corporations (S corps).
LLCs are legal business structures that you form with your state, while S corps are tax classifications you can elect through the IRS. They’re not mutually exclusive — you can form an LLC and choose S corp for your tax designation.
This approach can combine the legal protection and flexibility of an LLC with the potential tax savings of an S corp. Here’s what both these business terms mean, along with tips on how to choose the right status for your small business.
Key Points
• LLCs and S corps are not mutually exclusive — an LLC is a legal business structure formed with your state, while S corp is a tax classification you elect through the IRS.
• An LLC offers flexible membership with no limits on the number or type of members, lighter compliance requirements, and personal liability protection for your assets.
• S corp status offers personal liability protection similar to an LLC but comes with stricter rules, including a maximum of 100 shareholders and more formal recordkeeping requirements.
• With S corp status, you pay yourself a reasonable salary subject to payroll taxes, while remaining business profits can be taken as distributions, reducing your self-employment tax burden.
• Choosing S corp taxation generally makes sense if your business earns at least $60,000 in annual profit and you can manage the additional administrative and compliance requirements.
What Is an LLC?
A limited liability company, or LLC, is a type of business entity that separates your personal assets from your business obligations. This gives you liability protection, meaning your personal assets won’t be at risk if your business runs into financial trouble.
LLCs are popular among small business owners and freelancers because they’re relatively easy to form and maintain. To register as an LLC, you must file articles of organization with your state and pay a filing fee from $35 to $500. You’ll also pay an annual fee to maintain your LLC status.
LLCs are flexible business structures, as there are no limits on your business’s number or type of members. LLCs also have lighter compliance requirements than some other types of business entities, though they’re generally advised to hold annual meetings.
Understanding the pros and cons of an LLC can help you decide if this structure makes sense for your business.
How LLC Taxation Works
The IRS treats single-member LLCs as sole proprietorships and multi-member LLCs as partnerships unless they elect to be treated as corporations. While these two LLC types file different tax forms, they’re both treated as pass-through entities. That means your profits and losses will pass through to your personal tax returns.
The business itself doesn’t pay federal income taxes; instead, the business owners will report their revenue on their personal tax returns. LLC benefits don’t include any reduction of self-employment tax; you’re still responsible for paying self-employment taxes on your business profits.
That net business income is subject to a self-employment tax of 15.3%. The 12.4% Social Security portion of that self-employment tax applies to your first $184,500 in earnings, while the remaining 2.9% Medicare portion has no cap.
You also have the option of electing an alternative tax structure for your LLC, such as C corporation or S corporation.
What Is an S Corp?
Unlike an LLC, an S corporation isn’t a type of business entity under state law. Instead, it’s a tax designation you can select with the IRS by filing Form 2553.
To be eligible for S corp status, you’ll need to have an eligible business structure, such as an LLC or corporation. Choosing S corp taxation has the potential to reduce your self-employment tax bill.
Similar to LLCs, S corp status also offers liability protection for your personal assets. However, it has stricter requirements, such as a maximum of 100 shareholders and more formal recordkeeping requirements.
Plus, the business must be owned by U.S. citizens or residents and is only permitted to issue one class of stock.
How S Corp Taxation Works
Similar to LLCs, S corps are pass-through entities, meaning profits pass through to personal returns rather than being taxed at the corporate level. But they also have a major difference in terms of how self-employment taxes apply.
When your business elects S corp status, you pay yourself a “reasonable salary” for your work. This salary is subject to payroll taxes, including both the employer and employee portions of Social Security and Medicare.
Any remaining profits are distributed to you as shareholder distributions. These distributions are subject to income tax but not the 15.3% self-employment tax.
Let’s say, for example, your business earns $150,000 in profit. If you paid yourself a reasonable salary of $80,000, you wouldn’t have to pay self-employment taxes on the remaining $70,000.
While you could save thousands in self-employment taxes, you may also have to invest a few thousand dollars per year to file payroll tax returns, maintain corporate records, and potentially hire an accountant or payroll provider.
You’ll generally come out ahead with S corp status if you make at least $60,000 in profit each year and can handle the additional compliance requirements.
Key Differences Between an S Corp and LLC
LLCs and S corps share some overlap, particularly in terms of pass-through taxation and personal liability protection. But they also have major differences that can affect your business operations and tax bill. Here’s a closer look at how they differ.
Management and Compliance
LLCs are more flexible than S corps when it comes to management and compliance requirements. They can be managed by members or designated managers, and this flexibility is written into your operating agreement.
S corps, on the other hand, call for a more traditional corporate structure and generally have to hold meetings every year. S corp owners also need to run payroll to pay themselves the requisite “reasonable salary.”
Ownership Rules and Costs
LLCs are more flexible when it comes to ownership rules. They can have one or multiple owners and include members such as foreign investors, trusts, and other businesses.
S corps have stricter ownership rules, including a cap of 100 shareholders and a requirement that all owners are either U.S. citizens or residents. Some trusts and estates can qualify as shareholders, but corporations, non-resident aliens, and partnerships cannot.
As for costs, LLCs ask for state filing fees that usually range from $35 to $500, along with annual report fees. It doesn’t cost anything to elect S corp status with the IRS, but you may have to pay several hundred or thousands of dollars for payroll processing, accounting services, or similar support.
As mentioned, you must be an LLC or corporation to elect S corp status, so these costs will add to your other business formation and operating expenses.
When to Choose an LLC vs S Corp
Choosing between an LLC and an S corp comes down to your business stage and goals. Starting with an LLC could make sense if:
• You want a simple, flexible structure with minimal paperwork
• You’re looking for personal liability protection, which doesn’t come with a sole proprietorship
• You’re in an early stage of business and may not yet benefit for S corp taxation, though you may be exploring startup business loans to grow your company
You may eventually choose to get taxed as an S corp if:
• Your business makes at least $60,000 in profit consistently each year
• You want to minimize your self-employment taxes
• You’re comfortable handling additional administrative and compliance requirements
• You plan to pay yourself a reasonable salary and take tax-advantaged distributions
Some business owners start as an LLC and elect S corp status once their profits are high enough and their tax savings would outweigh the additional payroll and accounting costs.
The Takeaway
Both LLCs and S corps can provide liability protection and pass-through taxation, but they’re not equivalent terms. An LLC is a type of business structure, whereas an S corp is a tax classification.
Some businesses start out as LLCs and later choose S corp status when they’re generating consistent profits. Opting for S corp status can make sense when your tax savings outweigh the additional costs and administrative work.
As your business grows, you may also focus on building strong business credit so you can qualify for competitive rates on small business loans.
Navigating these rules can be complex, so make sure you’ve done your homework before deciding. It’s often wise to work with a tax professional who can advise you on the best fit for your specific business.
Ready to grow your business? SoFi Small Business Loans can give you fast access to the capital you need. Check your eligibility in minutes.
FAQ
Can an LLC elect S corp tax status?
Yes, an LLC is eligible to elect S corp tax status by submitting Form 2553 to the IRS. It will need to meet S corp requirements, which include being a domestic company organized in the U.S. and having no more than 100 shareholders.
What is a “reasonable salary” requirement for S corp owners?
The IRS requires S corp owners to pay themselves a “reasonable salary” before taking tax-advantaged distributions. This salary should reflect what a similar business would pay a third-party to perform the same duties. Paying yourself too low of a salary could trigger an IRS audit.
How much do you need to earn before an S corp election makes sense?
While there’s no official minimum, you’ll generally start benefiting from S corp election once your business makes at least $60,000 in profits. Try to determine your break-even point when comparing self-employment tax savings with additional payroll costs and accounting fees.
What are the ownership restrictions for an S corp?
S corps have several ownership restrictions. An S corp can’t have more than 100 shareholders, and shareholders must be U.S. citizens or residents. S corps also can’t have corporate or nonresident alien owners and are limited to one class of stock.
Can you switch from an LLC to an S corp later?
You can start with an LLC and later elect S corp taxation for your business. You don’t have to change your LLC business structure to be taxed as an S corp. However, you will need to meet S corp requirements, which include rules around ownership and shareholders. You’ll also need to file Form 2553 by March 15 of the tax year in which you want the S corp status to take effect.
Photo credit: iStock/VioletaStoimenova
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