LLC (Limited Liability Company) and an S corporation are both corporate structures that, in the United States, allow pass-through taxation. The main differences between an S corp. and LLC are:
- S corporations are more restrictive on who the shareholders (owners) of the company can be.
- S corporations are required to pay a salary to those owners who work for the company and own more than 2% of the company. In contrast, LLCs are not obligated to pay a salary to its members (owners). This has tax implications for some companies like single-person ventures.
- S corporations are required to maintain and file formal records for the board and shareholder meetings.
- S corporations are allowed to have only one class of stock.
- It is a little easier to set up employee stock option plans for S corporations than for LLCs.
These differences are explained in more detail below.
|Suitable for||Smaller businesses with few shareholders||Small businesses with less than 100 shareholders, consisting of US citizens and/or resident aliens for income tax purposes.|
|Management Level||Only Members and managing members of the company||Officers, board of directors of the company|
|Taxation||Single taxation - Profit or loss are passed directly to members(top bracket 39.6%). Can elect to be taxed as a corporation.||Single taxation (Profit or loss are passed directly to shareholders)|
|Ownership||Members||Shareholders are owners of an S-Corp.|
|Choice of taxation structure given||Yes, it is a Single Member LLC - SMLLC or partnership for multiple members by default, and S or C Corporation (by election)||No. An S corporation chooses to be taxed under Subchapter S of the IRC.|
|Legal entity||Separate entity from partners, but members may be held liable for non-fiscal obligations||Separate entity from shareholders (owners), who cannot be normally held liable for any fiscal obligations|
|Paperwork and records||Not much paperwork is required. Annual state reports are required to be filed with the appropriate fee; can file by mail but most states allow or mandate online filing||Formal board and shareholder meetings and minutes are required. Annual state reports are also required to be filed with the appropriate fee; can file by mail but most states allow or mandate online filing|
|Shareholders meeting||Not necessary, but should have recorded activities and/or advisory boards||Formal shareholders and board meetings are required|
|Continuity of life||Indefinite term||Indefinite term|
|Members needed to set up||1 or more||1 or more|
|Regulation of entity name||Differs with each state but mostly LLC or L.L.C. is added.||Can be Inc., Incorporated, Corporation or Corp.|
|Legal agreements||May not be required in some states. Should have an operating agreement with business records||Should have bylaws with business records|
|Self employment tax||Assessed on business profits of $400 or more||None|
|Non-permitted shareholders||None||Corporations, Partnerships, multi-member LLCs, LLPs Charitable Remainder Trusts|
|Permitted Owners or Shareholders||US citizens and/or resident aliens, non-resident aliens, corporations, partnerships, etc.||US citizens and/or resident aliens, estates of deceased individuals, bankruptcy estates, SMLLC, qualifed pension and profit sharing plans 501(c)(3) charities, ESBTs, QSSTs, and ESOPs|
|Stock rules||N/A||Only one class of stock permitted in an S-Corp.|
|Tax Year||Calendar year; can use any fiscal year if requirements are met.||Calender year; can use any fiscal year if requirements are met.|
|Salary for owners or shareholders||No; Single Member LLCs and LLC-partnerships members are not employees thus salaries must not be paid themselves; they are allowed withdrawals||Yes, must be paid to shareholders owning more than 2% and provides services to their business; not optional mandatory|
|Due dates||15th day of the fourth month of the following year; extensions extend for addtional 6 months(SMLLC) and 5 months (partnerships)||15th day of the third month of the following year; extensions extend for addtional 6 months|
|Distributions||Withdrawals throughout the business operating year; allowed provided the distributions don't prevent the company to pay its current operating obligations.||allowed throughout the business operating year, allowed after salaries are paid to the 2% or more owner-shareholders.|
Formation of LLC vs. S-corp
Typically, forming an LLC only requires a state filing (usually to the Secretary of State's office). The state filing typically consists of information such as:
- Members: All LLCs must have at least one member. LLC members are the owners of the LLC much as shareholders are the owners of a corporation or the partners of a partnership. Like shareholders, a member's liability to repay the LLC's obligations is limited to his or her capital contribution. Members may be natural persons, corporations, partnerships, or other LLCs.
- Membership Interest: A member's ownership interest in the LLC is called a membership interest. Membership interests are often divided into standardized units which, in turn, are often called shares. Unless otherwise provided for in the operating agreement, a member's right to control or manage the LLC is proportionate to their membership interest.
- Manager: LLCs are, by default, managed by their members in proportion to their membership interests. Many LLC operating agreements, however, provide for a manager or board of managers to run the day-to-day operations of the LLC. The managers are elected or appointed by members and may also be removed by members. A member may also be a manager, often called the managing member (similar to the managing partner of a partnership).
- Articles of Organization: All LLCs must file evidence of their existence with the secretary of state (or some governmental office) of the state where they choose to be organized. The Articles of Organization serve this purpose and are the LLC version of a corporation's Articles of Incorporation. Although the specific information that must be included in the Articles of Organization varies by state, all LLCs must disclose their company name (which must conform to rules set forth by the state of organization), appoint a statutory agent and disclose their valid business purpose. The fees associated with filing the Articles of Organization also vary by state.
- Operating Agreement: The Operating Agreement of an LLC is the document most important to its success because it determines, defines, and apportions the rights of the members. Because the various LLC statutes offer so much flexibility (see discussion below), and the default statutory rules do not fit most LLC's needs, Operating Agreements must be drafted carefully and with much discussion and agreement between the prospective members.
Depending upon the city where the LLC is operating, a filing with the city may also be required. A Federal Tax ID (also called Employer Identification Number) is also required for an LLC that has employees.
An S corporation is a corporation that elects to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code of the IRS. The formation typically requires a state filing, obtaining a Federal Tax ID and an S election. The state filing typically consists of:
- Articles of Incorporation
- Corporate Bylaws
- Written consent of incorporator
- Resolutions of the first meeting of the Board of Directors
If a corporation meets the requirements of S corporation status and wishes to be taxed under Subchapter S, its shareholders may file Form 2553: "Election by a Small Business Corporation" with the Internal Revenue Service (IRS). The Form 2553 must be signed by all of the corporation's shareholders. If a shareholder resides in a community property state, the shareholder's spouse generally must also sign the 2553.
The S corporation election must typically be made by the fifteenth day of the third month of the tax year for which the election is intended to be effective, or at any time during the year immediately preceding the tax year. Some states such as New York and New Jersey require a separate state-level S election in order for the corporation to be treated, for state tax purposes, as an S corporation.
Qualification for S corporation status
In order to make an election to be treated as an S corporation, the following requirements must be met:
- Must be an eligible entity (a domestic corporation, or a limited liability company).
- Must have only one class of stock.
- Must not have more than 100 shareholders.
- Spouses are automatically treated as a single shareholder. Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.
- Shareholders must be U.S. citizens or residents, and must be physical entities (a person), so corporate shareholders and partnerships are to be excluded. However, certain tax-exempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders.
- Profits and losses must be allocated to shareholders proportionately to each one's interest in the business.
If a corporation that has elected to be treated as an S corporation ceases to meet the requirements (for example, if as a result of stock transfers, the number of shareholders exceeds 100 or an ineligible shareholder such as a nonresident alien acquires a share), the corporation will lose its S corporation status and revert to being a regular C corporation.
Limitations of LLCs
While LLCs can have different "classes" of stock, this is usually accomplished by complicated operating agreements. Corporate law (as applicable to C and S corporations) is more established and therefore, investors and venture capitalists prefer to invest in corporations vs. LLCs. Defining and setting up employee stock option plans is also complicated with LLCs. However, it should be noted that since S corporations can only have 1 class of stock, companies usually choose to lose their S corp status when they accept investments (because investors typically demand preferred stocks). See Common Stock vs Preferred Stock.
Management and Operation
S corporations, like C corporations, are managed by a board of directors, elected by shareholders. Day-to-day operations are managed by officers who are appointed by directors.
LLCs can be member-managed or can have a team of managers. This flexibility is similar to a partnership and allows LLCs to outline management duties in their operating agreement, with an optional board of managers.
Taxation of an LLC vs. S corp
While employee Medicare and FICA taxes, as well as state taxes are not affected by a company's corporate structure, federal income tax treatments are different for LLCs and S corporations. The corporate tax rate is usually lower than the personal income tax rate. However, in the case of C corporations, there is double taxation because (a.) The corporation is taxed on profits, and (b) when these profits are distributed to shareholders (owners), the owners are taxed on these dividends.
S corporations can bypass this double taxation by reporting the entire income on the personal income tax returns of the shareholders. This is done in proportion to the ownership of each shareholder in the company. Not only does this allow bypassing double taxation, it also means that the losses incurred by the company can be reported on the shareholders' personal income tax return, thereby reducing their tax liability. C corporations carry their losses forward to offset them against future profits of the company.
An LLC can choose to be taxed either as an S corporation or a C corporation.
For S corporations, shareholders report income on Form 1120S, Salaries on Form W-2 and Profit distribution on Schedule K-1. For LLCs, members report income on their personal income tax Form 1040 Schedule C OR Form 1065 & Schedule K-1 for profit distributions. LLCs may also opt to be taxed as C or S corporation. If an LLC opts to be taxed as a C corporation, tax reporting is on Form 1120 for income, Salaries on Form W-2 and Profit distribution on Form 1099-DIV.