LLC vs. Corporation vs. S-corp: What’s the difference?

There is a lot of misinformation on social media regarding the differences between an LLC, a corporation, and an S-corporation. This post will clarify some of those differences. The main thing to remember is that an S-corp is not a type of entity you can set up but a tax classification for legal entities like LLCs and corporations to elect. If someone offers to set up an S-corp for you, they’re either setting up a regular corporation or an LLC and then filing the paperwork to elect to have that entity taxed as an S-corp. There is no such thing as a legal entity called an S-corp.

To summarize the information below, LLCs are generally easier and less expensive to set up and maintain while still providing the same tax and liability benefits as a corporation. We generally find that it makes the most sense for clients to set up an LLC and then be taxed as an S-corp once they reach a certain level of income to ensure the tax savings outweigh the additional costs of having the LLC with S-corp status.

LLC

LLC stands for Limited Liability Company, and it is a type of legal entity that is established at the state level. Generally, the Secretary of State within each state has the authority over legal entities, and they maintain the database of current and former LLCs that exist within their state. Most LLCs have LLC at the end of their name, e.g., “Your Sample Company, LLC.” An LLC that only one person owns is taxed by default as something called a “disregarded entity” by the IRS, meaning it effectively doesn’t exist in the eyes of the IRS and will be taxed the same as if it didn’t exist, so usually that means it will be reported directly on your personal tax return, subject to applicable income and self-employment taxes. LLCs with more than one owner (including two spouses in most states) have a default tax classification of a partnership, which requires a separate tax return, and the items of net income and tax credits flow through to the owners’ tax returns to be reported there. LLCs also have the option to be taxed as either a standard corporation or as something called an S-corporation (named because it appears in the Internal Revenue Code under subchapter S). We’ll talk about these classifications later but note that an LLC can be taxed differently depending on its owner(s) needs, which can provide significant flexibility.

Pros:

• An LLC is simple to set up and doesn’t require a significant amount of ongoing paperwork to maintain.

• LLCs provide the same level of personal liability protection as a corporation if they are operated correctly.

• LLCs have several options for how to be taxed at the federal level (generally, states will follow federal taxation), providing flexibility to owners.

Cons:

• LLCs require some additional ongoing paperwork in order to continue to operate.

Corporation

A corporation (sometimes called a C-corp to distinguish it from an S-corp) is another type of legal entity established at the state level and overseen by the Secretary of State within each state. Most corporations have Inc. or Co. at the end of the name to indicate the type of legal entity, e.g., “Your Sample Company, Inc.”. Corporations require additional paperwork and compliance in order to continue operating when compared with an LLC. Corporations do not have the option to be reported directly on an individual’s income tax return and instead require a separate tax return. The default corporation tax classification does not pass through any items to owners; instead, the corporation directly pays taxes, and then any amounts the corporation distributes to owners as dividends are taxed again at the owner’s level (this is referred to as double taxation). It used to be a significant additional expense to have the profit from the business taxed twice (as income and as dividends), but the Tax Cuts and Jobs Act of 2017 reduced the corporate income tax rate so that double taxation isn’t as big a problem.

Pros:

• Corporations provide owners with personal liability protection when operated correctly.

• Corporations can be taxed either as a standard corporation or as an S-corporation.

 Cons:

• Corporations require significant paperwork and documentation to maintain. Most states require corporations to file annual returns as well as hold documented annual shareholder meetings, which requires additional costs to stay in compliance.

• Corporation income is effectively taxed twice, although the impact isn’t as significant anymore since the corporate income rate was decreased.

S-corporation

An S-corporation (S-corp) is named for the part of the Internal Revenue Code that establishes the rules for this type of taxation. As a reminder, an S-corp is not a type of legal entity. It is only a tax classification that establishes the rules for how your entity (usually an LLC or standard corporation) will be taxed at the federal level (many states now also follow the federal taxation laws for S-corps). You elect this type of taxation by filing Form 2553 with the IRS, and it can be done anytime during the tax year preceding the year in which it will take effect or within 75 days of the beginning of the effective tax year. The IRS has several requirements for entities that want to be taxed as an S-corp:

• Must be filed as a U.S. corporation

• Can maintain only one class of stock

• Is limited to 100 shareholders or less

• Shareholders must be individuals, estates, or certain qualified trusts

• Requires each shareholder to consent in writing to the S Corporation election

• Requires each shareholder to have a US Social Security Number

• Requires each shareholder to be a US Citizen or permanent resident alien with a valid United States Social Security Number

•  Must have a tax year ending on December 31

Most of these are fairly straightforward and won’t have an impact on most situations. The main benefit of S-corp taxation is that the net income from an S-corp is not subject to self-employment tax like your net income from a sole proprietorship would be, which can save up to 15.3% in taxes. Additionally, an S-corp is a passthrough entity and does not pay taxes at the entity level; instead, items of net income and tax credits are passed through to the owner(s) tax returns, and the amounts are only taxed once as opposed to the double taxation of a standard corporation. It is important to note that owners of an S-corp who also work in the business need to pay themselves as employees of the business, and those wages are still subject to self-employment/payroll tax. Be sure to work with a qualified tax and business advisor to ensure you are complying with all rules and regulations.