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By default, a single-member limited liability company (LLC) is taxed like a sole proprietorship, and a multi-member LLC is taxed like a partnership. However, LLC owners can choose to be taxed as an S-corp. By doing so, business owners can often reduce their self-employment taxes.
When starting a small business, many entrepreneurs end up deciding between two types of business entities—LLC vs. S-corp. According to the National Small Business Association, about 42% of businesses are structured as S-corporations, and 23% of businesses are LLCs.
There are some important tax and structural differences between LLCs vs. S-corps. Many small business owners aim for the best of both worlds by registering their company as an LLC and electing S-corp tax status. This gives the business owner the legal and organizational benefits of an LLC, but the IRS treats the business as an S-corp for tax purposes.
Here, we’ll explain more about the similarities and differences between LLCs vs. S-corps. We’ll show you how to elect S-corp taxation and work though some examples about which business structure will save your company more money.
A limited liability company (LLC) is a business entity structure that’s recognized by all 50 states. In order to form an LLC, you must register your business with the state and file articles of organization, in a process that’s similar to incorporation.
Once the LLC is established, the owners, called members, receive certificates showing their level of ownership in the business, similar to stock certificates in a corporation. It’s possible for an LLC to have multiple owners or a sole owner. Although not legally required, most LLCs have an operating agreement that outlines the rights, responsibilities, and financial contributions of each member. An LLC may be member-managed or manager-managed. In a manager-managed LLC, one of the members or an appointed individual from outside the company makes day-to-day business decisions.
LLC members enjoy limited liability, meaning that they are not personally responsible for debts and obligations that are incurred in the ordinary course of business. Compared to a corporation, LLCs typically have fewer recordkeeping and reporting requirements to comply with. As we’ll explain more in a minute, LLCs also have great flexibility when it comes to taxation.
There are two types of corporations that a business owner can set up—an S-corp or C-corp. A C-corporation is the traditional type and is subject to a corporate tax on business profits and personal income tax on dividends.
An S-corporation is a more limited type of corporation. An S-corp can have no more than 100 individual shareholders, all of whom must be U.S. citizens or residents, and no more than one class of stock. S-corps offer pass-through taxation. This means shareholders report business income and losses on their personal tax return and pay their personal income tax rate on any profits.
When you compare LLCs vs. corporations, corporations have more reporting requirements. However, a corporation is the best business structure for companies that hope to raise money from investors because shares can be easily provided in exchange for money. Like LLCs, corporations offer shareholders limited liability from corporate debts and lawsuits.
Both LLCs and S-corps are pass-through tax entities. This means that business owners report their share of the company’s profits and losses on their personal tax return and pay their personal income tax rate on any business income. Apart from this similarity, there are some fundamental tax differences between an LLC and S-corp. Here’s what you need to know about the tax differences between an LLC vs. S-corp.
If you form an LLC and do nothing else, the IRS will tax you according to the default tax treatment for LLCs. By default, a single-member LLC is taxed as if it were a sole proprietorship. This means the owner reports business income and losses on a Schedule C and attaches it to their personal tax return. There’s no need for the LLC to file a separate business tax return.
By default, a multi-member LLC is taxed like a partnership. Each member of the LLC reports their share of the company’s income, losses, credits, and deductions on Schedule K-1 (Form 1065). Each member is taxed on their share of the business’s profits at their personal income tax rate.
In addition to business income taxes, members in an LLC must pay self-employment taxes on all company profits. Self-employment taxes cover Medicare and social security taxes for business owners. The current self-employment tax rate is 15.3%.
At first glance, it might seem like an S-corp is taxed just like an LLC. Each shareholder reports their share of the company’s profits and losses on a Schedule K-1, and profits are taxed at the shareholders’ personal income tax rates. The S-corp files Form 1120S with the IRS for informational purposes.
The biggest difference is that S-corps can help you save money on self-employment taxes. With an LLC, each member is considered a business owner who has to pay self-employment taxes. With an S-corp, a shareholder who actively works for the company is considered an employee, and only their salary is subject to self-employment taxes. Distributions outside of salary (also called dividends) are not subject to self-employment taxes.
Of course, business owners cannot evade self-employment taxes by paying themselves only through distributions. The IRS requires S-corp owners to pay themselves a reasonable salary given their job responsibilities and level of experience. For example, you likely can’t pay yourself an annual salary of $10,000 as the owner of an S-corp tech startup. The IRS carefully scrutinizes owner salary levels, and businesses that understate salary could face an IRS audit. When in doubt, you can look to sites like Glassdoor and PayScale to find good salary estimates.
Small business owners can choose to legally set up their business as an LLC but opt to file taxes as an S-corporation. From a legal standpoint, the company is an LLC. You don’t need to sell shares or comply with reporting responsibilities for corporations. To the IRS, however, the company is an S-corp. For many businesses, this is a win-win situation that allows you to enjoy the legal and structural benefits of an LLC and the tax benefits of an S-corp.
Tax differences between LLCs and S-corps are important, but there are other differences as well. These differences only apply if your business is structured as a corporation. If your company is organized as an LLC, and you simply elect S-corporation tax status, these differences won’t apply to you.
Ultimately, there are many factors that will drive your choice between an LLC vs. S-corp, but profitability should be one of the key factors. If your business has income left over after you pay yourself a reasonable salary, then you should consider electing S-corp tax status. With the excess income, you can pay yourself a distribution, which isn’t subject to self-employment taxes. This can save you thousands of dollars and increase your bottom line.
To make things easier to understand, let’s look at an example of how much a business would pay under default LLC tax status and as an S-corp. To begin, let’s assume that you’re the sole owner of ABC Bakery LLC, which generated $100,000 in net taxable income in 2018 after deducting allowable business expenses. For the sake of simplicity, let’s assume that you have no other income outside of the business and that you’re a single filer.
Now, assume that you opt to have ABC Bakery taxed as an S-corp. The business has $100,000 in net taxable income, out of which you take $60,000 as a reasonable annual salary. You pay yourself the remaining $40,000 as a distribution. Here’s how your taxes would play out:
In this example, you end up paying less in total taxes if you choose to be taxed as an S-corp. However, this is only a viable option if you’re in a position to divide your business’s total income into two parts—one for salary and one for distributions. Should you choose S-corp tax status, your tax filing will also be slightly more complicated because you’ll need to set up tax withholding (for your own salary, as well as that of any employees).
Photo credit: IRS.gov
In order to have your LLC taxed as an S-corp, you have to file Form 2553 with the IRS. For most businesses, the deadline to file the form is March 15 of the tax year in which you want the election to take effect.
An LLC is eligible to be taxed as an S-corp if the following are true:
Form 2553 can be downloaded from the IRS website. If you prefer more help, we recommend asking a tax professional or business lawyer. Legal help sites like LegalZoom also offer filing services for Form 2553.
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When deciding on a business structure, LLC vs. S-corp is an important choice you’ll have to make. Many business owners choose to structure their companies as an LLC for operational flexibility, but then opt to be taxed as an S-corp. This might be a good solution if your business is already generating income. The S-corp tax status can end up saving you hundreds, even thousands, in taxes. Like always, we recommend talking with a tax professional to understand how the choice between an LLC vs. S-corp impacts your business specifically.