One of the primary decisions you need to make when you set up your business is what type of entity makes the most sense for your mission.
While C Corporations and nonprofit organizations are fairly self-explanatory, many small business owners still hesitate to make a clear distinction between what makes a limited liability company and an S Corporation.
Each one presents its own unique set of benefits and drawbacks, though the differences may have eluded you thus far. We’re pitting these two business structures against each other to help you decide which best fits your company. S Corp vs. LLC: place your bets.
What Is an LLC?
As the name indicates, LLCs are best known for the limited liability protection that they provide to businesses. More specifically, an LLC structure allows a business owner to separate their personal assets from the business itself, and as a result, their company’s assets and/or debts cannot impact their personal finances.
Because of this distinction — as well as its pass-through taxation, much like a sole proprietorship — LLCs are among the most popular types of businesses out there, particularly for small businesses or those just starting out.
Of course, that doesn’t mean an LLC is automatically the best option for your business. You’ll need to do some digging to be certain. For instance, companies looking to raise investment funds would be better served with something more robust, and businesses in finance and other industries may be prohibited from registering as an LLC in their area.
However, small business owners can enjoy key benefits of larger corporations without overcomplicating their finances. As more and more entrepreneurs pop up, the LLC is fast cementing its status as the go-to business entity for up-and-coming professionals.
The Benefits of an LLC
Liability: We’ve already covered how the limited liability protection of LLCs are so integral to their usefulness. After all, it’s right there in the name! However, we can’t overstate enough how valuable the separation of your business and personal assets is.
Taxation: Whenever you start a new business, there’s always the matter of taxes. In the case of an LLC, your company wouldn’t be responsible for its own taxes. Rather, it is taxed as part of your personal income. You can even choose what entity it is taxed as.
Ownership: Whereas other business entities must face ownership restrictions that might prohibit foreign or corporate entities to become a member of your company, an LLC features no such limitations.
Profit distribution: Much like ownership, this is another area in which LLCs enjoy much more freedom. In this case, the profit shares may be broken down and distributed however you see fit, even if it differs from the percentage of ownership.
Compliance: Perhaps the greatest appeal for LLCs — aside from the liability protection — is that this business entity features minimal effort to remain compliant with regulations. Unlike corporations, you control your meetings and documentation.
The Limitations of an LLC
Taxation: No, you’re not seeing double. Just as pass-through taxation is an asset, it can also create problems when it comes to your self-employment taxes. You might wind up with higher taxes as a result of this structure, in addition to federal inclusion costs.
Record-keeping: While limited liability protection goes a long way toward simplifying your finances, you do have to devote a bit more time to ensure you document your personal finances independent from your business.
Banking: Likewise, you’ll want to use separate credit cards and checking accounts for your business and personal assets. This will reinforce the distinction between the two and make it that much easier to retain your liability protection.
Termination: Although corporations persist regardless of the shareholders that may depart, an LLC will be terminated and disappear if a member exits the organization. Bear this in mind as you build your team.
What Is an S Corporation?
Like the LLC, an S Corp is a pass-through business entity, but it offers a distinct set of advantages from the LLC. For instance, S Corp stock is easily transferable, unlike LLC ownership, and an S Corp may actually reduce liability on your self-employment taxes (as discussed above, that can be dicey for LLCs).
As your company grows, this can beyond invaluable for the future of your company. In fact, the S Corp tax code was introduced as a way to inspire the creation of more small businesses by relieving the double taxation that plagues the traditional corporate structure.
Qualifying for an S Corp is trickier than an LLC too, with a few IRS requirements to meet. First, your company must be based in the United States. You also must not violate the limited ownership rules (more on that below), and you can have no more than 100 total shareholders and one class of stock. Lastly, as with the LLC, certain types of companies — such as those in finance and insurance — may not be eligible to register as an S Corp.
The Benefits of an S Corp
Limited liability: Keeping your personal and business assets separate is still very much a priority for owners of an S Corp. Shareholders are not personally liable for company finances, and personal assets cannot be sought after by creditors.
Taxation: Everything we said above regarding taxation still applies. Except for capital gains and passive income, your S Corp would be exempt from federal income tax. The pass-through nature prevents you from facing that dreaded double taxation.
Income: In keeping with the tax theme, S Corps retain the ability to characterize income a number of different ways. You may choose to pay yourself a salary and/or dividends, a tactic that can reduce self-employment tax liability altogether.
Ownership transfer: As mentioned above, you can transfer shares of your S Corp much easier than in most other business entities. You can even shift ownership without significant tax consequences or early termination of the business and remain compliant.
The Limitations of an S Corp
Ownership: Although ownership can be transferred with ease, you must meet a number of different requirements when it comes to the actual ownership structure. We’ve touched on this briefly, but it’s vital that you bear this in mind and how it may hinder your future growth.
Wages and dividends: The ability to designate income as wages/dividends is certainly useful, but it could also draw the ire of the IRS if abused. If your activity is deemed inaccurate, you might be asked to recharacterize your income and pay higher taxes.
Tax qualification: If you make any errors when it comes to qualifying your business as an S Corp, you could be facing the disastrous fate of losing your company’s S Corp status. Considering the number of specific restrictions, this is easier than you may think.
Although forming an LLC will probably be the best option for most small businesses, you may find yourself in a circumstance when an S Corp would be better suited.
As always, you’ll need to take some time and consideration before you make your final decision. But once you are ready to register your company, Incfile is absolutely here to help.
We aim to aid small business owners like you in getting started with their latest ventures, including incorporation and all that it entails. You don’t have to do it alone, not when our extensive resources and expert assistance can make the road ahead so much easier. For more on how we can help, check out our website and get started today!
Ben Gran is a freelance writer from Des Moines, Iowa. Ben has written for Fortune 500 companies, the Governor of Iowa (who now serves as U.S. Secretary of Agriculture), the U.S. Secretary of the Navy, and many corporate clients. He writes about entrepreneurship, technology, food and other areas of great personal interest.