Whether you’re just starting a business or considering changing your business structure, a common first step is comparing the LLC and the S corporation. While a limited liability company and an S corporation share some characteristics, they also have distinct differences. Get familiar with each before deciding which might be right for you.
How LLCs and S corps are similar
LLCs and S corps have much in common:
- Limited liability protection. The owners of LLCs and S corporations are not personally responsible for business debts and liabilities. Instead, the LLC or the S corp is responsible for the entity’s debts and liabilities.
- Separate entities. LLCs and corporations are separate legal entities created by a state filing. (Once formed, a corporation can choose to be taxed as an S corp by filing IRS Form 2553 “Election as a Small Business Corporation” with the IRS.)
- Pass-through taxation. Both LLCs and S corporations are pass-through tax entities. (Although an LLC can choose not to be taxed as pass-through if the owners so choose.) With pass-through taxation, no income taxes are paid at the business level. Business profit or loss is passed through to owners’ personal tax returns. Any necessary tax is reported and paid at the individual level.
- Ongoing state compliance requirements. Both LLCs and S corporations are subject to certain obligations imposed by the state corporation and LLC statutes, such as having to appoint and maintain a registered agent, filing annual reports and paying annual fees, notifying the state of certain changes such as a change of name, registered agent or entity type and having to qualify to do business in states outside of the formation state.
Key differences between LLCs and S corps
There are several key differences between an LLC and S corp pertaining to ownership, management, and ongoing formalities.
Note: An LLC and an S corp are simply different ways a company can be taxed and the rules it needs to follow to stay compliant with the IRS. Neither option is “better” than the other. The choice of how to incorporate depends on the business type, size, and goals.
Ownership
IRS rules restrict S corporation ownership, but do not restrict ownership of LLCs. IRS imposes the following rules on LLCs and S corps:
- LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners).
- Non-U.S. citizens/residents can be members of LLCs. However, S corporations cannot have non-U.S. citizens or residents as shareholders
- S corporations cannot be owned by corporations, LLCs, partnerships or many trusts. This is not the case for LLCs.
- •LLCs are allowed to have subsidiaries without restriction.
- S corporations cannot issue classes of stock with different financial rights, such as giving some shareholders a preference to distributions over other shareholders. In contrast, LLCs do not have these kinds of restrictions.
Transferability of ownership
S corporation stock is freely transferable, if IRS ownership restrictions are met. An LLC membership interest (ownership) typically is not freely transferable — approval from other members is often required. (LLC members may specify otherwise in their operating agreement if they wish.)
Allocation of profits and losses
S corporation shareholders receive their profits and losses based on their percentage of ownership (e.g. a 50% shareholder receives 50% of the profits and losses). LLCs can allocate profits and losses on almost any basis they want (e.g. a member with a 50% ownership interest could be entitled to 90% of the profits and losses).
Can an S corp own an LLC?
An S corp can own an LLC. However, an LLC would generally not be able to own an S corp. An exception to this rule is if the LLC is 1) is a single-member LLC that is treated as a disregarded entity for federal income tax purposes and 2) meets the eligibility requirements to be an S corporation shareholder.
Management
- Owners of an LLC can choose to have members (owners) or managers manage the LLC. When members manage an LLC, the LLC is much like a partnership. If there is only one member (what’s known as a (what’s known as a single-member LLC), it is quite similar in this regard to a sole proprietorship. If run by managers, the LLC behaves more like a corporation because the members do not take part in daily business decisions.
- S corps have directors and officers. The board of directors oversees corporate affairs and handles major decisions but not daily operations. Instead, directors elect officers who manage everyday business activities. Shareholders do not manage the business and affairs.
Ongoing formalities
Corporation laws have more rules about how to manage a corporation than LLC laws do. As a result, S corporations must follow more detailed internal procedures. While LLCs do not have to follow these procedures, though some advisers suggest that they should adopt them.
- Required formalities for S corporations include adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.
- Recommended formalities for LLCs include: Adopting an operating agreement, issuing membership shares, holding and documenting annual member meetings (and manager meetings, if the LLC is manager-managed), and documenting all major company decisions.
Taxes
While LLCs and S corporations are both pass-through entities, S corporations may have preferable self-employment taxes compared to the LLC because the owner can be treated as an employee and paid a reasonable salary. Taxes, including FICA, are taken out of that salary. After paying this salary, the remaining corporate earnings might be classified as unearned income, which does not face self-employment taxes. For more details and to see how this applies to your situation, please speak with your accountant or tax adviser.
However, LLCs also have the option of being taxed as an S corporation or as a corporation. So, LLCs offer more flexibility in how they can be taxed for income tax purposes vs. an S corporation.
Some states tax S corporations as corporations instead of at the personal level. Most states follow federal rules and treat S corporations as such, but a few do not. If you live in one of those states, you might be required to submit a state S corporation election form, pay taxes as another type of entity (such as a C corporation), or meet other state tax obligations. Some states do not impose taxes on S corp income at all.
When to choose an LLC over an S corp
Many small businesses consider S corporations to be complex and burdensome. If you're a small business owner looking to protect your personal assets, an LLC is a good choice and is the most popular business structure for small enterprises.
Related: How to form an LLC
When to choose an S corp over an LLC
If you are thinking of forming a corporation, an S corp can be an alternative option.
For instance, S corporations are similar to traditional C corporations in how they are managed and owned. S corps have shareholders, directors, and officers. Shareholders own the company's stock. Directors set corporate policies and oversee the company’s strategy. Officers handle the day-to-day operations.
If you’re looking for strong personal asset protection, plan to seek significant financing from others, or hope to sell stock in a publicly traded company, you will likely benefit from forming a C corporation and then filing for S corporation tax status.
Related: How to form an S corporation, How to convert an LLC to an S corp
Making your choice
As you decide which business structure is best for you, try our Incorporation Wizard Tool to compare multiple business types by multiple key considerations.
