Whether you’re just starting a business or thinking of changing your business structure, a common first step is comparing the LLC vs. 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.
The similarities of LLCs and S corps
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, as the owner of the business, is responsible for its debts and liabilities.
- Separate entities. LLCs and corporations are separate legal entities created by a state filing. (Once formed, a corporation that wishes to be taxed as an S corp can file IRS Form 2553 “Election as a Small Business Corporation” with the IRS.) However, LLCs and corporations are formed under and governed by very different state business entity statutes.
- 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.
The IRS rules restrict S corporation ownership, but not that of limited liability companies. IRS restrictions include the following:
- 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; S corps may not have non-U.S. citizens/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. LLCs are not subject to similar restrictions.
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 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.
- 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 single-member LLC), it is quite similar in this regard to a sole proprietorship. If run by managers, the LLC more closely resembles a corporation as members will not be involved in the 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 daily business affairs. Shareholders do not manage the business and affairs.
Corporation laws have more mandatory requirements regarding how a corporation is to be managed than LLC laws. Therefore, S corporations face more extensive internal formalities. While LLCs are not required to, some advisers recommend that they, too, follow internal formalities.
- 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.