One of your first steps to making your self-employment path or a new business official is registering as either an LLC or S-Corp.
Although registering under these designations requires certain fees and takes some legwork to understand which version is best for your situation, the potential tax benefits can be worth it.
Here’s what to know about the differences between an LLC and an S-Corp and how to decide what’s best for you.
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What Is an LLC?
Chances are you’ve seen the letters “LLC” before but aren’t totally sure what the acronym means. LLC stands for “Limited Liability Company.” It’s a business entity that functions like a hybrid between a sole proprietorshipand a sole proprietorship.
Not all LLCs are created equal. Within the broad umbrella of LLCs, there are different types, such as:
- Single-Member LLC. This is an LLC with one owner who has the sole responsibility for taxes, debts, and business income.
- General Partnership. An LLC with multiple members is known as a general partnership; all owners take responsibility for debts, taxes, and business income.
- Family Limited Partnership. In this type, families own the partnership and can use it to manage assets such as property.
The type of LLC and number of members in your organization can influence your taxes. For example, a domestic LLC with two members is classified as a partnership and viewed as a corporation for federal tax purposes.
Forming an LLC
When it comes to membership in an LLC, laws vary by state. Some states, such as Colorado, Illinois, and Texas, don’t allow minors to form an LLC. Before getting started with creating an LLC, keep the following in mind:
- Fees. There are fees to form your LLC and fees involved in upkeeping your LLC. For example, in California, the filing fee for the articles of organization is $70. If your California-based LLC makes more than $250,000, you will have to pay a fee in proportion to your earnings.
If you use a lawyer to help form the LLC and file the paperwork, you should also anticipate legal fees.
- Forms. The forms you’ll need to create your LLC vary greatly by the type of organization you’re creating. At a minimum, you’ll need the articles of organization that describe the key information about your LLC, such as its name, the members’ names, and address.
You might also need an operating agreement that describes the structure of your company. Even if your state doesn’t require this form, it’s best practice to have it.
- Taxes. LLCs will pay both state and federal taxes. For example, every LLC in California pays an annual $800 tax. At the federal level, an LLC will either be taxed as a partnership or corporation, depending on how you file.
Why Choose an LLC?
Why use an LLC? People commonly choose LLCs when starting a new business for several reasons. Here are the advantages they see.
- Limits Your Liability: Through an LLC, your assets are protected from the actions of the company. If your company starts accruing debts and creditors come calling, this could be a huge benefit of an LLC.
- Low Maintenance: An LLC doesn’t require many documents to start or maintain, so if you’re intimidated about starting a company or simply don’t have enough time, this could be a stress-free and low-cost option.
- Federal Tax Advantages: Profits from an LLC pass through the entity to members, which means you won’t be taxed on a corporate level but on your personal tax return instead.
Losses also pass through to your personal tax returns, which can lower your personal tax liability. LLCs are a common strategy to help with freelancer tax advantages.
Tax Implications for an LLC
When it comes to an LLC’s tax advantages, it’s important to keep in mind that you’ll decide how your LLC is taxed by how you structure your LLC.
For example, a single-member LLC isn’t treated as a separate entity for tax purposes. If you have a single-member LLC, you’ll need to fill out Schedule C when you do your personal income taxes and carry the net income over to your personal tax return.
If you have a multiple-member LLC, you can pay tax as a partnership. Again, the tax would pass through to the members depending on their involvement.
You could also choose to classify your LLC as a corporation or an S-Corp. This could be beneficial if your income is already high and you don’t want additional income passing through to you on your federal tax return.
What Is an S-Corp?
An S-Corp is a corporation that passes all corporate income and losses to shareholders for federal taxes. Shareholders report the income and losses on their personal income taxes, which can influence the rate at which they are taxed.
The obvious benefit is that a shareholder of an S-Corp can avoid double taxation of corporate and individual income tax.
An S-Corp is a tax status, so an entity could technically be an LLC and an S-Corp in some cases. Not all corporations can qualify for S-Corp status.
Here are the eligibility requirements:
- Be Domestically Incorporated
- Have Only Allowable Shareholders (Could Be Individuals, Trusts, Estates, or LLCs)
- Have a Maximum of 100 Shareholders
- Have Only One Class of Stock
- Not Be an Ineligible Corporation
Forming an S-Corp
If you’re thinking of forming an S-Corp, here are some of the finer details to keep in mind:
- Fees. When filing an S-Corp, you’ll have to consider state and federal filing fees, in addition to changes in operating costs such as insurance.
- Forms. In addition to state forms, which vary, you’ll also have to file a federal Form 2553 to become an S-Corp.
- Taxes. S-Corps could be liable for federal income and employment tax. You can review the taxes that apply to your situation through the IRS website. You’ll also be subject to state taxes, which can vary by state. For example, California assesses S-Corps at 1.5% as well as a minimum $800 franchise tax.
Why Choose an S-Corp?
Business owners of bigger corporations have multiple options for organizing their entity, such as an S-Corp or a C-Corp.
For business owners who choose to go the S-Corp route, here are the benefits often cited:
- Tax Advantages. Profits and losses pass through to your personal tax returns, so you can get taxed at a lower rate and avoid double taxation. This could be particularly helpful if you’re in the start-up phase of your company and have many losses.
- Protects Your Liability. Forming an S-Corp can help protect your personal assets if your company is sued or owes a debt.
- Avoid Self-Employment Tax. While S-Corps must pay a reasonable salary to their employees, you could also classify some of your income from the S-Corp as a distribution, avoiding paying self-employment tax on your total earnings.
Disadvantages of LLC vs. S-Corp
While there are benefits to both the LLC and S-Corp structures, there are also distinct disadvantages. Depending on your business goals, size, and operations, one might be more suitable than the other.
Let’s delve into some of the drawbacks of each structure to give you a more comprehensive view.
LLC Disadvantages
- Self-Employment Taxes: Profits that pass through to members of an LLC may be subject to self-employment taxes. This can potentially lead to higher overall taxes for the business owner compared to some benefits provided by S-Corps.
- Limited Growth Potential: As your business grows and you potentially look to raise funds, the LLC structure may not be the most attractive to investors compared to corporations.
- Varying State Rules: Each state has its own set of rules and fees for LLCs, which can create confusion for businesses operating in multiple states.
- Less Formal Structure: While this can be an advantage for some, others may find that the lack of structure can lead to disputes or misunderstandings among members.
S-Corp Disadvantages
- Strict Qualification Rules: There are restrictions on ownership for S-Corps, including a cap on the number of shareholders and who/what can be a shareholder. This can limit the potential for growth or investment opportunities.
- Salary Requirements: Owners who work in the business must pay themselves a “reasonable salary,” which could be higher than what they might otherwise take from the business.
- Paperwork and Formalities: S-Corps have stricter operational processes, including the requirement for a board of directors, regular shareholder meetings, and more. This can increase administrative burdens.
- State Tax Variations: Some states don’t recognize the S-Corp designation, meaning you might end up paying state taxes at the corporate level, reducing some of the federal tax advantages.
LLC vs. S-Corp: Side-By-Side Comparison
| ENTITY | UNIQUE FEATURES | LIABILITY PROTECTION | TAXATION CONSIDERATIONS | DRAWBACKS |
|---|---|---|---|---|
| LLC | Unlimited Members, Easy to Start and Manage, Highly Flexible | Members Are Not Liable | Income and Losses Pass Through to Shareholders Unless the LLC Elects to Be Viewed as a Corporation | Could Be More Expensive to Set Up Than a Sole Proprietorship |
| S-Corp | Suited for Small Corporations, Requires a Board of Directors and Has Annual Filing Requirements | Shareholders Are Not Liable | Income and Losses Pass Through to Shareholders With No Tax for the Corporation | Can Only Issue One Type of Stock, Limited to 100 Shareholders |
The Bottom Line – LLC or S-Corp: Which Should You Choose?
Deciding how to set up your business now is important as you continue to grow your company. Not only could it save you fees and headaches down the road, but the right entity could leave you with tax advantages that make an impact on your personal income.
When making your choice, consider the cost of setting up each entity and the complexities of running them. You’ll want to weigh your immediate business needs against any plans for the future growth of your company.
