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Both the LLC and S-Corp classifications give businesses and their owners some valuable benefits, but it’s essential to choose the option that’s right for your business structure and goals. This guide includes everything you need to know to better understand the differences between the LLC and an S-Corp, the pros and cons you can expect to see from each. We’ve gone into detail about how these classifications affect your taxes, personal liability, and even how you run your business.
Why Understanding LLCs and S-Corps Is So Important
If your business is operating as a Sole Proprietor or General Partnership, it might be time to explore a different business entity type. A business classification like an LLC or a tax classification like an S-Corp can bring many benefits, including personal asset protection, tax benefits, and increased options for the number of shareholders you want to establish.
But LLCs and S-Corps each have specific restrictions, and choosing the wrong option for your business could result in you paying extra taxes or not being able to run your business in the way that you want. For example, if you are operating a single-owner business and want increased liability protection and tax benefits, then an LLC might be the right choice for you. But if you were to become an S-Corp, you would need to establish a board of directors and would face increased reporting requirements. This would be overwhelming and unnecessary for a single-owner business.
The more you understand the pros and cons of an LLC and an S-Corp, the better you’ll be able to choose the entity that’s right for your business and your goals.
Pros and Cons of an LLC
A limited liability company, or LLC, is a business entity or business classification that affects how your business is taxed and what might happen if your business got into legal trouble. This structure helps to protect business owners’ personal assets, so if your business is sued, your personal assets, like your home, can’t become part of the lawsuit.
It’s important to understand the pros and cons that come with an LLC.
Business Management and Structure
When you operate your business as an LLC, your business can have multiple owners – also called members. These members can be other businesses or individuals, and there’s no limit to the number of members a single LLC can have.
Unlike a corporation, an LLC offers plenty of flexibility in terms of how you manage the business. Your members can manage the LLC and be involved in daily decision-making. Alternatively, managers can oversee the business’s daily operations, which is ideal if your members don’t have time to be involved with your business, or if your members have limited business or industry experience.
Most states also have minimal management requirements for LLCs. Most won’t require that you hold an annual meeting, or that you have a board of directors. This makes for less administrative work and allows you to better focus on running your business.
There are some restrictions about LLC member turnover that can be a hassle. Some states require that an LLC be dissolved if a member leaves the business or dies. The remaining members will have to start a new LLC if they wish to continue to operate. This can be an inconvenience and time-consuming, and it makes it even more important to verify that your business members are fully invested in the business for the long term.
Limits on Liability
One of the major appeals of an LLC is that this business entity provides its members with liability protection. If a business goes bankrupt or is sued, creditors can’t collect assets, including investments and homes, from the LLC’s members.
While this protection might seem enticing and ideal at first glance, it’s not 100% guaranteed. It is possible to mishandle your LLC and risk your personal assets, particularly if you don’t keep your business accounts and transactions separated from your personal transactions. Other business practices, like tax fraud, or if a member intentionally commits a crime, can also jeopardize the liability protection an LLC offers. If a judge rules that you haven’t run your business properly, that judge can determine that your personal assets can be claimed to satisfy your business debts.
An LLC may provide its members with several tax benefits. With an LLC, it’s easy to distribute profit to members. Giving members profit distributions means you don’t have to necessarily establish salaries. These profit distributions aren’t taxed, and members report the distributions in their personal tax returns, instead.
LLCs also allow for pass-through taxation, which means that the business income passes through into each member’s personal tax return. There’s no corporate income tax imposed on those profits, and this helps to avoid a situation where profits are taxed twice. This can amount to substantial tax savings and makes your business’ tax process significantly easier. Members take care of tax reporting with their individual returns instead of relying on the business to process taxes on that income first.
With an LLC, members may also enjoy helpful tax deductions, like the Qualified Business Income deduction. This deduction lets the members of an LLC deduct 20% from the net income of the business, further reducing the taxes they’ll pay.
While an LLC can simplify taxes, the taxes on your business profits are just one of the tax types that you’ll need to worry about. LLCs and their members may still be subjected to self-employment taxes, franchise taxes, employment taxes, excise taxes, and more. It’s always best to consult a tax professional to help you understand the tax implications and requirements of an LLC.
Forming an LLC can increase the credibility of your business. This can be valuable if you’re working to establish your business and if you need to build public trust in your operations.
Simple Startup Procedures and Minimal Costs
If you decide that an LLC is right for your business, starting one is relatively easy. The article of organization fees will vary from state to state–in some states they may be less than $100, while in other states they can cost multiple hundreds of dollars. However, startup paperwork requirements for an LLC are relatively minimal, which makes an LLC a more user-friendly option for business owners.
Pros and Cons of an S-Corp
An S-Corp, or S corporation, is a tax classification under the Internal Revenue Service. With an S-Corp, your business will be taxed as a partnership. The S-Corp provides some of the same benefits that you’ll enjoy with an LLC, but it affects how you run your business differently and has some important implications when it comes to taxes and business stock.
Business Management and Structure
Unlike an LLC, where significant ownership transfers can require that the LLC be terminated, an S-Corp offers much more flexibility with ownership transfers. Owners can transfer their shares freely without resulting in excess taxes or complications for the business entity.
Your business will need to follow strict operational requirements when it becomes an S-Corp. You will need to establish a board of directors and hold an organizational meeting. During that first meeting, you’ll need to adopt bylaws and open a business bank account.
You’ll need to record the details of that first and all subsequent meetings. This leads to increased administrative requirements and can be time-consuming. The requirement to create a board of directors and hold meetings makes an S-Corp an impractical choice for small businesses or single-owner businesses.
As an S-Corp, you can sell shares in your company, but you’ll be limited to 100 shareholders or less. You are also limited to selling only one class of stock.
Limits on Liability
An S-Corp helps to protect its shareholders’ personal assets, ensuring that shareholders don’t have any personal liability for any debts or limitations that the business might have. If a business loses a lawsuit or goes bankrupt, creditors can’t pursue shareholders’ homes or bank accounts in an effort to settle business debts.
Like an LLC, an S-Corp operates as a flow-through business and doesn’t pay federal taxes on profits in most cases. Instead, the business owners report their income on their personal tax returns, and taxes are then applied to at the personal level. This helps to avoid taxing income and profits twice, saving business owners excess taxes.
Under an S-Corp, your shareholders won’t have to pay self-employment tax on the business profits that they receive. However, they will be taxed on their salary, and your S-Corp will be required to pay a salary to any owner who’s also an employee. That salary will be taxed, and the employee and the corporation will each pay half of Social Security and Medicare taxes. Because of this requirement, an S-Corp’s tax perks are most valuable when the business earns enough to pay not only a reasonable salary, but to also have leftover profits that are then paid out to shareholders, too.
While these tax benefits can be appealing, operating a business as an S-Corp can cause the IRS to pay closer attention to your business finances. The IRS may monitor how you’re making payments, like dividends or salary disbursements to owners and employees. The IRS might require you to recategorize some of these payments and will make sure that you’re appropriately categorizing them. Changing these payment categories could alter how they’re taxed and might lead to increased taxes for employees or owners.
Additional Pro: Increased Credibility
An S-Corp is a more complicated business structure that requires specific reporting, the creation of a board of directors, and meetings. Forming an S-Corp demonstrates that you are committed to your business and to your shareholders. It can help to boost the trust that suppliers, customers, and even investors have in your company. This trust could lead to increased business opportunities.
Additional Con: Strict Qualification Requirements
Starting an S-Corp is complicated, and only certain businesses qualify. To start an S-Corp, your business will need to:
- Be a corporation located within the United States
- Have shareholders that are individuals, trusts, and estates (partnerships, corporations, and non-resident alien shareholders aren’t permitted)
- Have 100 shareholders or less
- Have just one class of stock
- Not be a corporation like certain financial institutions, insurance companies, and international sales corporations that aren’t eligible
These requirements may eliminate some businesses from being able to become an S-Corp.
If you do wish to become an S-Corp, you’ll need to complete a significant amount of paperwork. You’ll need to file Articles of Incorporation and a Certificate of Incorporation with your state, and will need to pay filing fees and any franchise fees that might apply. The cost of these fees varies depending on your state.
Next, you’ll need to file Form 2553 with the IRS to obtain the S-Corp status.
Once those documents are filed, you’ll need to establish your board of directors and hold your first meeting.
How to Pick the Right Structure for Your Business
Both an LLC and an S-Corp offer tax and personal liability benefits, but they differ significantly when it comes to how businesses operate. Your business will also need to meet some strict requirements to qualify to become an S-Corp.
When deciding which structure is right for your business, it’s important to think about how the structure might change your business. You’ll also want to consider the filing fees and annual fees associated with each structure, and these can vary depending on your state.
The LLC and S-Corp are excellent business structure options, but they’re most suitable for different types of businesses. The LLC tends to be a good option for a sole proprietor or single-owner business. The S-Corp is often better suited for larger businesses with partners and shareholders. Keep in mind, though, that those are generalizations. You’ll need to carefully consider the pros and cons that each option offers your business.
The more you understand how an LLC and S-Corp operate, the better you’ll be able to determine which is right for you. It’s always best to consult an attorney and an accountant to discuss your individual business and any effects that each structure might have for your business.