One of the questions we often hear from startup founders involves whether to form an S-corporation or a limited liability company (LLC). Certainly there’s an easy answer that can save your future company time and money, right? Well, it’s a bit more complicated than that. Forming an S-corp vs. LLC is not always a straightforward proposition, in part because these are two fundamentally different things.
It’s true! While S-corps and LLCs are often lumped together in the same conversation, they differ in kind: an S-corp is a federal tax classification, while an LLC is a type of legal business entity operating under state law. Corporations (another type of business entity) may qualify for S-corp status if they meet certain requirements. LLCs may also qualify to be taxed as an S-corp, though in order to do so they must follow strict filing procedures akin to those of a corporation.
For the sake of this guide, we’ll make the comparison more apples-to-apples by assuming that we are talking about a corporation when we say “S-corp.” Just be aware that it’s not always an “either/or” distinction.
S-corp vs. LLC: At-a-glance comparison
- What is an S-corp?
- What is an LLC?
- Benefits of S-corp tax status for an LLC
- When to form a S-corp vs. LLC
What is an S-corp?
S-corp is a tax classification that’s commonly used by corporations that meet a certain set of requirements. If a corporation qualifies for S-corporation status, it can elect to pass its business income, losses, deductions, and credits through to its shareholders’ personal tax returns for federal income tax purposes.
But before we go too far down the tax rabbit hole, let’s first define what a corporation is.
What is a corporation?
A corporation is a legal entity that is separate and distinct from its shareholders, directors, and officers. For legal purposes, a corporation essentially acts as its own person. It may be strange to think of a corporation as a sort of non-human person, but it helps in understanding that a corporation has rights and exists as an entity apart from the people who run it.
Like an LLC, a corporation protects its owners from personal liability. This means that the business owners(aka shareholders) are generally not personally liable for any debts or obligations belonging to the business.
While corporations offer strong personal liability protection, they are also generally subject to more rigorous requirements than other types of businesses. For example, a corporation must have corporate bylaws, conduct annual meetings, elect a board of directors, and follow strict rules regarding record-keeping.
S-corp vs. C-corp: What’s the difference?
C-corp and S-corp are two different types of corporations for tax purposes. To understand the appeal of S-corporation status, it helps to understand how regular C-corporations are taxed. Why? Because S-corps are specifically designed to avoid the “double taxation” issue that arises with C-corps.
A C-corp is a corporation that’s taxed separately from its owners. As noted above, this can lead to the issue of “double taxation.” A corporation must pay corporate income tax on its earnings, and its shareholders must also pay taxes on dividends distributed at the individual level. The dividends are essentially taxed twice—first at the corporate level, then at the individual level. Contrary to what the IRS may think, twice the taxes does not equal twice the fun.
An S-corp is a corporation that passes through corporate income, losses, deductions, and credits to its shareholders for federal tax purposes. This effectively avoids the double taxation issue. Many states also recognize S corps the same way the federal government does, though some don’t (and some tax S-corps on profits above a certain limit).
While a C-corp has advantages when it comes to attracting venture capital, corporations that meet certain requirements may opt for S-corp tax status to lower their overall tax burden. These requirements are strict, however, and not all corporations (or LLCs, for that matter) will be able to qualify for S-corp status.
How to form an S-corp
Setting up a corporation—whether it’s an S-corp or a C-corp—means you must file articles of incorporation with the state agency that oversees corporate filing. These articles of incorporation include some key information about your company, including its name, address, and the type and number of shares.
You’ll also need to create a set of corporate bylaws, find a registered agent (in some cases), elect a board of directors, hold board and shareholders’ meetings, and issue your first shares of stock. You may be able to find a law firm or service that offers a templatized set of these documents, which can make the process a bit easier.
Finally, you’ll have to actually meet the requirements for S-corp status.
S-corp requirements
Subchapter S of the U.S. Internal Revenue Code specifies that a corporation must meet the following requirements for S-corp status:
- be incorporated and operating within the U.S.
- have only allowable shareholders (i.e. U.S. citizens, certain trusts, and estates)
- have 100 or fewer shareholders
- have only one class of stock
Some corporations may not be eligible for S-corp status even if they meet the above requirements. These include certain financial institutions, insurance companies, and domestic international sales corporations.
If a business entity meets the above requirements, it must submit IRS Form 2553, Election by a Small Business Corporation. An LLC that wants to elect S-corp status for tax purposes must also file Form 2553.
But let’s not get ahead of ourselves. First, let’s define what an LLC actually is.
What is an LLC?
A limited liability company (LLC) is a type of business entity that protects a company’s owners from personal liability for any debts and/or losses that the company accrues.
If we think of business entities as existing on a continuum, an LLC would fall somewhere between a sole proprietorship or partnership and a corporation. Indeed, it has certain things in common with all of the above. Like a corporation, an LLC offers limited liability protection. It is also a pass-through entity for tax purposes by default—a characteristic it shares with sole proprietors and partnerships.
Some startup founders and entrepreneurs may need a relatively simple way to protect themselves and their fellow owners from personal liability risk. LLCs may be an entity type to consider in this case. They have some downsides relative to corporations, but they can also offer more flexibility in terms of their ownership, management structure, and reporting requirements.
How to form an LLC
LLCs operate under state jurisdiction. This means you’ll need to verify the state-specific process for forming an LLC with the Secretary of State in the state where you’re considering incorporating your business.
In general, most states will require you to file articles of organization, which is a legal document that includes basic information about your business, its members, and its purpose. You may also have to pay state fees when filing articles of organization.
After completing the initial steps to set up your LLC, it’s generally recommended that you also create an operating agreement that outlines the various LLC members’ rights, roles, and responsibilities.
Benefits of S-corp tax status for an LLC
As we mentioned above, LLCs are taxed as sole proprietorships or partnerships by default. This means that taxes can be “passed through” to individual LLC members.
Hold on a second, you might be thinking. Isn’t that the main benefit of an S-corp? If so, what possible reason could an LLC have for wanting to be taxed as an S-corp? There are in fact a few tax advantages that may lead an LLC to seek S-corp status.
Employment taxes
When a business entity is taxed as a partnership, the owner of that entity is considered an owner for tax purposes. But when an entity is taxed as an S-corp, the owner is considered an employee (assuming they work for the business).
Why does this matter? It has to do with how Social Security and Medicare taxes are paid.
When an LLC is taxed as an S-corp, only the wages paid to its employees (including the owner) are considered earned income subject to Social Security and Medicare taxes. So, if the owner receives a salary, that income would be subject to Social Security and Medicare taxes. Any additional business profits would be passed through the S-corp and reported as a distribution on the owner’s personal income tax return—which means they wouldn’t be subject to employment taxes.
Of course, the best way to avoid employment taxes in an S-corp would be to give yourself a salary of $0. But the IRS requires a shareholder-employee to receive “reasonable compensation” before non-wage distributions may be made.
The qualified business income (QBI) deduction
Another reason an LLC might be interested in S-corp status involves the QBI deduction included in the Tax Cuts and Jobs Act of 2017.
This deduction allows business owners of sole proprietorships, partnerships, S-corps, and some trusts and estates to deduct up to 20% of their qualified business income from their taxes. Businesses that don’t pay employee wages may not qualify for this deduction, so an LLC with an owner or owners but no employees may not qualify. An S-corp whose owner is an employee, however, may be able to qualify for the QBI deduction.
Tax law can get complicated quickly. If you’re curious about whether an S-corp might lead to the best corporate tax situation for your business, we recommend seeking advice from a tax professional before taking the plunge.
When to form an S-corp vs. LLC
If you’re wondering which corporate structure makes the most sense for your startup, you have a lot to consider. Small business owners who crave simplicity and flexibility might find a lot to like in an LLC. But at a certain point, it may be time to consider the benefits of forming or transitioning to a corporation. If your goal is ultimately to raise money from a large pool of investors, a corporation (specifically, a C-corp) has advantages that an LLC can’t match.
Wherever you’re at in your startup journey, Pulley is here to help. Our cap table management platform makes it easy for startups to keep track of the equity they issue and avoid costly mistakes when raising funds. Schedule a call with one of our experts today, and let’s chat about equity.
