As a result of the COVID-19 quarantine, and the consequential remote work many people have had to engage in, a huge surge in monthly business applications has occurred since the start of 2020. Due to this tremendous growth in entrepreneurship, it is important that these owners are aware of the optimal business structure for their individual situations.
While many are satisfied with remaining as a sole proprietorship (or general partnership, if there are multiple members), it is almost always beneficial to incorporate your business as an LLC due to the numerous benefits it provides. However, this does lead to some confusion arising between LLCs and S Corps, which many believe to be synonymous.
Deciding how to organize a small business can seem difficult when this is not true in reality. This article will elucidate the key differences between LLCs and S Corps as well as when it is optimal to choose one over the other.
What Are They?
An LLC (or limited liability company) is a type of business structure that enables companies to protect the personal assets of their owners. Unlike sole proprietorships and general partnerships, the personal assets of the company’s owner cannot be pursued in order to reclaim business debts.
This works because of the limited liability protection that is inherent to LLCs. By creating a demarcation between the business’s assets and the owner’s personal assets, only the former is permitted to be used to the end of satisfying the business’s debts. This means that the owner’s house, car, and other assets are safe in the event of the business’s bankruptcy.
Contrastingly, the owners of sole proprietorships have their personal assets laid bare to be ravaged by the likes of creditors and lawsuits. This is the primary reason it is advised that small businesses form themselves as LLCs, particularly since the formation process is relatively straightforward and simple.
On the other hand, S-Corps (or S corporations) are not really comparable to LLCs as they are not even a business entity. Indeed, they are a type of tax status or designation that LLCs and corporations can choose to be classified as.
Forming an LLC is the initial step needed to create an S-Corp. From there, the LLC must meet the following criteria before it can apply to the IRS for S-Corp status:
- Owners of the LLC earning a “reasonable salary” for their role
- Consistent payment of distributions and earning of a profit
- Further IRS S-Corp conditions
LLC & S Corp Tax Differences
Opting to be recognized as an S-Corp allows an LLC to be taxed in a way that differs from the standard method of taxing an LLC. Put simply, S–Corp status enables the business owners to be recognized as employed by their business (rather than self-employed) so that they are no longer liable to pay the self-employment taxes of a standard LLC.
Standard LLCs are subject to ‘passthrough taxation’, which describes the way in which tax ‘passes through’ the company and is paid by owners instead. Rather, instead of being subject to the ‘double taxation’ that corporations are, the company’s profits pay half as much.
This is because LLCs do not need to pay corporation tax. Instead, the owners take their share of the profits, and then pay personal income and self-employment tax, whereas the owners of a corporation would have to pay corporation tax on the profits, then personal income tax on the share they allocated themselves.
Choosing to be taxed as an S Corp changes this up slightly. Since the owners are no longer recognized as self-employed (because they are now recognized as employees of their company), they no longer need to pay self-employment tax.
As long as the business adheres to the IRS guidelines of paying their owners “reasonable compensation” based on the role they perform, the owner will only be subject to income and payroll taxes on the salary they choose to pay themselves. Further, only income taxes must be paid on distributions.
Therefore, by eliminating self-employment tax, electing S-Corp status reduces the overall taxes that are owed by a company. This enables them to invest more in any other aspect of their business they might require.
For a more detailed exploration of the s corp vs llc debate, please see TRUiC’s article on the topic.