An LLC is a legal business structure created under state law. An S corporation is a federal tax election for eligible businesses.
These are not always competing choices. An LLC can elect to be taxed as an S corporation by filing IRS Form 2553. An S corporation can have no more than 100 shareholders.
LLC vs. S Corp: At a Glance
| Feature | LLC with Default Tax Treatment | LLC Taxed as an S Corporation |
|---|---|---|
| What it is | A state-law legal entity | A federal tax election |
| Liability protection | Usually comes from the LLC, subject to state law and proper formalities | Usually comes from the underlying LLC or corporation, not the tax election |
| Federal tax treatment | Single-member LLCs usually report income on the owner's return; multi-member LLCs usually file as partnerships | Income passes through Form 1120-S and shareholder Schedule K-1 |
| Owner compensation | Owners usually take draws or guaranteed payments, depending on the tax classification | Working owners generally receive reasonable W-2 wages |
| Self-employment tax | Usually applies to active business income | Usually does not apply to the shareholder's distributive share, but payroll taxes apply to wages |
| Payroll requirements | Usually simpler | Requires payroll, wage reporting and employment tax filings |
| Ownership rules | Flexible in many cases | Eligible shareholders only, no more than 100 shareholders and one class of stock |
| Administrative burden | Usually lower | Usually higher |
| Common fit | New, small or flexible businesses | Profitable businesses where possible payroll-tax savings justify the added work |
The Main Difference: Legal Structure vs. Tax Election
An LLC determines how a business is formed and governed under state law. It can have one or more owners, called members, and it usually separates the business's liabilities from the owners' personal assets.
An S corporation describes federal tax treatment. It does not describe the business's legal formation. A corporation can elect S corporation status, and an eligible LLC can make the same election.
For example, a business can legally be:
Smith Consulting LLC, taxed as an S corporation
The business remains an LLC under state law. For federal tax purposes, it follows S corporation rules.
How an LLC Is Taxed
The IRS usually applies these default federal tax classifications:
- A single-member LLC is usually treated as a disregarded entity. The owner reports the business activity on a personal tax return.
- A multi-member LLC is usually treated as a partnership.
- An LLC can elect to be taxed as a corporation.
- An eligible LLC can elect S corporation taxation by filing Form 2553.
Under default taxation, an active owner of a single-member LLC usually pays self-employment tax on the business's net earnings. Members of an LLC taxed as a partnership may also owe self-employment tax on active business income.
The main benefit of default LLC taxation is simplicity. The owner usually does not need to run payroll for personal compensation, and the business has fewer tax and recordkeeping requirements.
How an S Corporation Is Taxed
An S corporation generally passes its income, deductions, losses and credits through to its shareholders. The company usually files Form 1120-S, and shareholders report their allocated income on their personal tax returns.
A working S corporation owner is usually paid in two ways:
- W-2 wages for services performed for the business.
- Shareholder distributions from the company's remaining profits.
Wages are subject to payroll taxes. The shareholder's distributive share of S corporation income usually is not subject to self-employment tax.
An S corporation cannot label all owner compensation as distributions. A shareholder who works for the business must receive reasonable compensation before receiving non-wage distributions. The IRS can reclassify improperly low wages as taxable wages.
Why Business Owners Choose S Corporation Taxation
The potential tax benefit comes from separating some business profit from the owner's wages.
An owner may receive:
- A reasonable salary for the work performed; and
- Additional profit as a distribution.
That arrangement may reduce payroll taxes compared with treating all active business income as self-employment income. The possible savings must be compared with the added costs, including:
- Payroll processing
- Quarterly payroll filings
- W-2 and 1099 reporting
- Bookkeeping
- Form 1120-S preparation
- State taxes and required filings
- Corporate recordkeeping
S corporation taxation is more likely to make sense when the business has consistent profit beyond a reasonable owner salary. It is less useful when profits are low, irregular or barely cover the owner's compensation.
There is no single profit level that makes an S corporation election worthwhile. The result depends on the owner's salary, business profit, state taxes, payroll costs, retirement benefits and accounting fees.
LLC Advantages
An LLC is often a practical starting point because it allows flexible ownership and usually requires less administration.
An LLC May Be Preferable When:
- The business is new or revenue is unpredictable.
- The owner wants a simpler tax and bookkeeping setup.
- The business has modest profit.
- The owners want flexible profit allocations or ownership arrangements.
- The business may change its tax election later.
- The owners want to avoid running payroll for themselves at the start.
An LLC can later elect S corporation taxation if the business becomes consistently profitable and meets the eligibility requirements.
S Corporation Advantages
An S corporation may be worth considering when:
- The business produces reliable profit.
- The owner actively works in the business.
- Possible payroll-tax savings exceed the added payroll and accounting costs.
- The owners can manage payroll and corporate tax filings.
- The ownership structure fits S corporation rules.
S corporation income usually passes through to shareholders instead of being taxed as ordinary corporate income at the federal level. The corporation may still owe certain entity-level taxes, and state treatment varies.
Important S Corporation Restrictions
A business generally must meet these requirements to qualify for S corporation treatment:
- It must be a domestic corporation or an eligible domestic entity.
- It can have no more than 100 shareholders.
- Its shareholders must be allowable owners, such as individuals, certain trusts and estates, and certain tax-exempt organizations.
- It generally cannot have nonresident alien shareholders.
- It can have only one class of stock.
- It cannot be an ineligible business type, including some financial institutions, insurance companies and international sales corporations.
These requirements make S corporations less flexible than many LLCs. An LLC may be a better fit when the owners want multiple classes of ownership, corporate investors or special profit-sharing arrangements.
Which Has Better Liability Protection?
Neither "LLC" nor "S corporation" automatically guarantees personal liability protection.
An LLC usually provides protection because it is a separate legal entity under state law. An S corporation may also provide protection, but that protection comes from the corporation or LLC itself, not from the S corporation tax election.
Owners can weaken that protection by:
- Mixing personal and business funds
- Failing to keep separate records
- Using the business improperly
- Missing state filings
- Committing fraud or acting negligently
- Failing to maintain required insurance
State rules differ. Liability protection should be reviewed under the law of the state where the business is formed and operates. The U.S. Small Business Administration also notes that ownership, liability, tax and filing rules vary by state.
LLC vs. S Corp: Which Should You Choose?
For many new small businesses, the practical approach is to form an LLC first and consider an S corporation election after the business has consistent profit.
A default-taxed LLC is usually the better fit when simplicity and flexibility matter most. S corporation taxation deserves consideration when predictable profit creates possible payroll-tax savings that exceed payroll, accounting and compliance costs.
Before making the election, compare:
- Expected annual profit
- Reasonable salary for the owner's role
- Payroll taxes on wages
- Self-employment taxes under the LLC's default treatment
- Accounting and payroll costs
- State income, franchise and S corporation taxes
- Ownership and investment plans
- Retirement and health benefit arrangements
An eligible LLC makes the election by filing IRS Form 2553. The usual deadline is two months and 15 days after the beginning of the tax year in which the election should take effect. Late-election relief may be available in some situations.
Bottom Line
An LLC is a legal structure. An S corporation is a federal tax classification.
For many owners, the choice is between an LLC with default taxation and an LLC that elects S corporation taxation. The first option is simpler. The second can reduce payroll taxes for a profitable, owner-operated business, but it adds payroll obligations, filing requirements and accounting costs.
A CPA or business tax attorney should model the numbers before the election is made.