LLC vs S-Corp: Which is Right for Your Small Business?

Nadav Shemer
LLC vs S-Corp: Which is Right for Your Small Business?
Although LLCs and S-Corps are often presented as alternatives to one another, they can actually be complementary. That’s because an LLC is a type of business structure, whereas an S-Corp is an IRS classification that grants a business (LLC or corporation) certain tax benefits.

An LLC Can Choose to Be Treated as an S-Corp

The benefit to forming your business as an LLC is that it combines the limited liability of a corporation with the operational flexibility of a sole proprietorship or partnership. 

By default, the IRS treats LLCs as pass-through entities where all profits and losses pass through to the owners (known as members). A single-member LLC is considered a ‘disregarded entity’ and is treated like a sole proprietor for tax purposes. A multi-member LLC (there are no limits on how many members an LLC can have) is treated as a partnership and taxed under Subchapter K of the Internal Revenue Code.

If you form an LLC, you are not obligated to accept your default status. For example, your LLC may elect to be treated as an S-Corp and taxed under Subchapter S of the IRS code. To do so, you must meet the minimum qualifying requirements outlined here and file IRS forms 2553 and 8832. This is something you can do yourself or with the help of a legal services provider (for $250, ZenBusiness will handle everything—from formation of LLC through to conversion to an S-Corp). Once the process is complete, your business will be considered an LLC for legal purposes and an S-Corp for tax purposes.

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Converting to an S-Corp Reduces Your LLC’s Tax Liability

An LLC is by default a pass-through entity for tax purposes, and becoming an S-Corp does not alter this status. As a pass-through entity, all your business’s profits, losses, deductions, and credits pass straight through to its members without being subject to federal corporate tax (and in most states: state corporate and franchise tax). This avoids the problem of double taxation on profits.

If LLCs already avoid double taxation, why bother converting to an S-Corp? The main reason is that it can reduce your members’ overall tax liability. In an LLC, members must pay 15.3% self-employment tax on all net earnings (12.4% for Social Security and 2.9% for Medicare). The benefit of converting to an S-Corp is that members can be treated as both owners and employees and payments made as dividends and salary. Payments made as salary are subject to self-employment taxes but payments made as dividends are exempt. The one catch is that you LLC can’t just pay everything in dividends; you must pay what the IRS considers a ‘reasonable’ salary to each member for the time, effort, and experience they bring to the table. 

Don’t Rush Out to Turn Your LLC into an S-Corp

While the requirements for registering as an LLC are very simple, electing to be treated as an S-Corp is more complicated. To become an S-Corp, your business must have only one class of stock (an LLC can have multiple classes), it must have no more than 100 shareholders (an LLC can have an infinite number), and all shareholders must be US citizens or resident aliens (whereas non-Americans can easily set up a default LLC in Delaware and various other states without ever actually being on US soil).

S-Corps can find themselves under scrutiny from the IRS, which often goes to great lengths to ensure that companies pay a reasonable amount in salaries and don’t just dish everything out in dividends. The IRS has been known to redefine dividends as salary and salary as dividends, subjecting S-Corp shareholders to additional taxes and other costs. In extreme cases, it has even stripped businesses of S-Corp status when they haven’t followed the rules.

Even if your LLC is eligible to become an S-Corp, there are circumstances where it is better and simpler to keep the default LLC tax classification. Certainly, if you and your fellow LLC members plan to re-invest profits in the business (meaning you don’t report them as taxable income), then there is little reason to become an S-Corp. 

Another thing to consider is your growth strategy. If you have plans to attract capital through the sale of shares, then an S-Corp will actually limit your options (because of the strict IRS requirements). In this case, you may be better off completing what is known as a ‘statutory conversion’ from LLC to corporation and accepting the default C-Corp tax status. In most states, all you need to do to achieve this is fill out a few documents and pay a filing fee. For around $199 plus state fees, a top legal services provider such as Swyft Filings will do all the work of converting to a C-Corp for you.

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Always Consult a Tax Advisor

We hope you find this guide helpful in choosing how to define your LLC. As always, we recommend consulting a tax advisor before making a decision. IncFile, a leading online legal services provider, offers a free 1-hour tax consultation to everyone who signs up for its business formation packages, including advice on how to choose the proper IRS tax election. Alternatively, your regular accountant or tax or legal advisor should be able to help you weigh up the pros and cons of being a default LLC vs being treated as an S-Corp.

Nadav Shemer
Nadav Shemer specializes in business, tech, and energy, with a background in financial journalism, hi-tech and startups. He enjoys writing about the latest innovations in financial services and products.