For all LLCs, the default tax structures applied to them will be “disregarded entity” for single-member LLCs, or “partnership” for multi-member LLCs. Not only are these standard for LLCs, they are in almost all situations the most appropriate. In the few situations where they are not, however, an LLC can opt to be identified as an S-Corp, provided they meet certain criteria. This is a type of tax classification that allows an LLC to opt to be taxed like a corporation in order to save on them. S-Corps and LLCs each have their own advantages that make them more or less beneficial for different businesses, the purpose of this article is to elucidate when each is preferential.
Advantages of an S-Corp
Unlike LLCs and corporations, an S-Corp isn’t a business entity, it’s a tax designation that can be applied to a business, provided it meets certain requirements. These requirements being that the business cannot have more than 100 owners – all of whom must be U.S. citizens or permanent residents; no other business entities may be owners either.
The main appeal to LLCs about opting to classify as an S-Corp is the money it allows the members to save on taxes; though this benefit will only become apparent if the business’s earnings are significant. For one, S-Corp owners save money on employment taxes by distributing their earnings to members and passive shareholders.
So long as it can be demonstrated that they have an active role in the day-to-day operations of the business, the owners will be considered employees of the company. Such owners must be paid a ‘reasonable’ salary (earned income) based on their position and industry, with the rest of the business profits distributed as dividends.
S-Corps, unlike their normal counterpart corporations, are also not subject to “double-taxation”. Owners of S-Corps, much like those of LLCs, are subject to “pass-through taxation”, whereby the business is not taxed, only the personal income the owners allocate themselves out of the business’s dividends.
Further, S-Corps maintain the personal asset protection of LLCs. This means that, absent of an express personal guarantee, a shareholder cannot be held personally liable for the debts of the business. Moreover, creditors cannot pursue their personal assets (i.e. house or bank accounts) of business owners in order to resolve the company’s debts.
Disadvantages of an S-Corp
Due to the more complex tax designation than a single member/partnership LLC that it inherently requires, an S-Corp can easily invite closer scrutiny from the Internal Revenue Service (IRS). This complexity can cause accounting errors and mistakes in filing which, if caught by the IRS, can result in a stripping of the business’s S-Corp status. This makes it critical to adhere to their regulations.
Additionally, since the number of shareholders the business can have is limited (as there can only be a maximum of 100 owners), this is not ideal if the business’s current goal is to attract investors.
Comparison with LLCs
Many of the advantages of classifying as an LLC for the sake of taxation mirror the disadvantages of classifying as an S-Corp. Principally, since there is no limit on the number of owners an LLC can have (unlike an S-Corp), with no restrictions on their classification or nationality, they are better for attracting investors. This makes them perfectly suited for new companies that are just starting out.
In a similar vein, LLCs are liable to pay self-employment tax on all net profits if they are taxed as a sole proprietorship or partnership, whereas S-Corps can of course avoid this entirely.
Final Take
An LLC and an S-Corp are two similar sorts of tax classification with their own advantages and disadvantages. In attempting to find an answer to the S-Corp vs LLC argument for a business, one should consider the long and short-term goals of their business before deciding which classification is more suited for it. Businesses that are well-established and can reliably earn enough money annually to save money even after paying the ‘reasonable salary’ should opt for that. Contrastingly, entrepreneurs who are only just founding their business, and are thus prioritizing attracting investors and growing their revenue, should choose the default tax status an LLC provides.
