LLC vs. S-corp Script
Hi, everyone.
I'm Priyanka Prakash, senior staff writer here at Fundera, and today I'm going to be
talking to you about LLCs vs S-corps, with a particular focus on the tax differences
since that is what is going to affect your company's bottom line the most.
Choosing a business structure is obviously a very important decision, and it really depends
on the specific circumstances of your company, as well as your future goals.
But I'm going to cover some general information that you should keep in mind when you're trying
to decide between an LLC or an S-corporation.
Now before getting to taxes, which is the big difference, there are a few other things
you should know.
First is formation.
Both LLC and S-corps are separate legal entities, which means you have to file documents with
the state in order to form the business.
With S-corporations, this document is called the Articles of Incorporation.
And with LLCs, this document is called the Articles of Organization.
Now even though they have slightly different names, both documents contain similar information,
such as your business's name, address, and registered agent.
You would go through your state’s Secretary of State or business filing agency to file
these documents.
The second category is liability.
Both S-corporations and LLCs offer limited liability protection for owners, which means
that the owner or owners aren't personally liable for the business’s debts and obligations.
Say, for example, you own a landscaping business and you organize it as an LLC and accidentally
injure a customer.
If the customer sues your business, they can only recover out of the business’s assets.
Your personal assets like your home or your car or your personal bank accounts are safe
from legal claimants and creditors.
That is a huge advantage over being organized as a sole proprietorship or a partnership
because your personal assets are safe.
The third category is management structure, and that's where LLC and S corp start to branch
off a little bit.
S-corps have a three-layer management structure.
Shareholders collectively own the business.
Shareholders elect the board of directors, who decide high level strategic and policy
matters.
And the board elects officers, like the CEO or the CTO or the CFO, who run the business
on a day to day basis.
Because S-corps can issue stock, they're actually better suited than LLCs for raising investor
money.
However, and this is important, S-corps are limited to 100 shares and a single class of
stock, which is a limitation that does not apply to traditional C-corps.
So just keep that in mind if you're starting a company and you're planning to raise funds
from investors or venture capitalists.
LLCs are owned by their members.
The members might run the business on a daily basis or they might elect one of the members
to serve as a manager.
They might also elect a professional manager from outside the organization, LLC members
own what is called as “membership units” in the business rather than stock.
Now we come to the biggest difference of all: taxes.
The nice thing about LLCs is that you can actually choose how you want your LLC to be
taxed.
And that kind of flexibility is really not available with other kinds of business structures.
By default, LLCs are taxed as pass-through entities.
That means that the business income, losses, credits, and deductions flows through to each
owner’s personal income tax return and are taxed at each owner's personal income tax
rate.
The LLC would file Form 1065 as an informational tax return, and each owner would use a Schedule
K-1 to actually fill out the information on their personal tax return.
Now, in addition to business income taxes, members in an LLC must also pay self-employment
taxes on all company profits.
Self-employment taxes cover medicare and social security taxes for business owners.
S-corps are also pass-through entities because business income and losses pass through to
the owners’ personal tax returns.
The S-corp files Form 1120S as an informational return.
Any shareholder also gets a Schedule K-1.
However, where the biggest difference is is in terms of self-employment taxes.
A potential advantage to S-corp owners is that you can pay yourself in two different
ways, either as salary or as distributions.
Only salary is subject to self-employment taxes; distributions are not.
So you could potentially save a significant amount of money by paying yourself through
distributions.
However, just keep in mind that the IRS does keep tabs on this.
You have to pay yourself a reasonable salary for your job title and industry, so you cannot
exclusively pay yourself in distributions and pay no self employment taxes.
That would not work with the IRS.
Where things get really interesting is, as an LLC, you can actually choose to be taxed
as an S-corp and get the tax advantages that come along with being an S-corp.
In other words, you're still considered an LLC from a legal and structural standpoint,
but you opt to file taxes as an S-corporation.
To elect S-corp status, you have to file Form 2553 with the IRS two months and 15 days after
the start of the tax year in which you want the change to take effect.
For most businesses that follow a calendar tax year, that’s March 15.
The last category we should discuss is compliance requirements.
Compliance is a little bit more difficult with an S-corp than with an LLC.
In most states, S-corps, like any kind of corporation, have to establish bylaws, holds
director and shareholder meetings, draft meeting minutes, issue corporate resolutions to make
important decisions, and issue stock certificates to sell stock.
In many states, there’s also an annual business tax on S-corporations called the franchise
tax.
Not following your state’s requirements could mean that you have to pay fines or back
taxes, or in a worst case scenario, you could even lose your corporation status, so it's
important to know your state’s requirements.
LLCs have it a little easier in terms of compliance.
There's a small handful of states that require LLCs to draft an operating agreement.
This is similar to corporate bylaws and contains the owner's rights and responsibilities and
the governing structure of the business.
And some states also have an annual franchise tax on LLCs.
But, that's really it in terms of compliance.
You're not required to hold shareholder meetings since there's no stock that you're issuing,
or director meetings.
You don't have to draft resolutions.
Holding meetings and keeping formal meeting minutes is recommended for any type of business,
but it's not required.
So, in terms of time and money, an LLC is easier to maintain than an S-corp.
So, it comes down to which should you choose—an LLC or an S-corp.
On the one hand, LLCs have more structural flexibility, and they're easier to maintain
than an S-corporation.
But S-corporations can help you save on employment taxes.
One compromise solution that often works well for small business owners is to elect S-corp
tax status for your LLC.
This essentially lets you remain an LLC from a legal standpoint, so you don't have to issue
stock or elect a board of directors or take care of those other corporation compliance
requirements.
But from a tax perspective, you get the advantages of being an S-corp.
You can treat some of your earnings as salary and some as distributions and potentially
save on self-employment taxes.
One case where an S-corp might be a better fit is if you're planning to raise funds from
an investor or a venture capitalist.
Most investors simply expect stock in return for contributing money to a business, so that's
important to keep in mind when you're planning financing for your business and if you plan
to raise money from investors.
Whether you choose to form your business as an LLC, an S-corp, or a different type of
business structure, we recommend IncFile for business formation.
You can simply go to their website Incfile.com.
Choose your entity type, as well as your state of formation, and click “Get Started.”
You'll see three different pricing tiers come up, as well as the fees for filing incorporation
or registration documents in your state.
Each pricing tier has a slightly different bundle of services, but all come with one
year of free registered agent service, which is a great deal.
Ultimately, it's important to look to your business's current circumstances as well as
your future goals in deciding whether to organize as an LLC, an S-corp, or an entirely different
business structure.
We recommend that you consult with a business lawyer if you have specific questions about
how to structure your company.
We hope this was helpful, and we wish you the best of luck.
Follow fundera.com/blog for more small business information, and subscribe to our YouTube
channel for more videos.
Thanks for watching, everyone.