Your business is probably set up as a Limited Liability Company (LLC), a sub chapter S-Corporation, or both. But what’s the difference, and under what circumstances would it make sense to change your LLC into an S-Corp?
An LLC is a type of business entity (as compared to a sole proprietorship or corporation), while an S-Corp is a tax election. An LLC is set up at the state level, while an S-Corp election is made with the IRS at the federal level (and filed with your state’s Secretary of State). Owners in an LLC are called “members”, while S-Corp owners are called “shareholders“.
Taxation of Business Income
Business income in an LLC flows through to the members to be taxed at their personal rate, and they are responsible for paying their own self-employment taxes (both the employer and employee sides of FICA and Medicare, a total of 15.3% of income). In contrast, S-Corp shareholders take a salary, and like other employees, pay 7.65% in payroll taxes with the business paying the other half. The business can then take a tax deduction for the payroll tax expense. Any additional business profits are distributed to S-Corp shareholders as dividends, which are taxed at a lower rate than regular income.
Setup and Maintenance
It’s easier and generally less expensive to set up and maintain an LLC, which makes it a good choice for a smaller business with one or just a few owners who want maximum flexibility and control over the business.
An S-Corp requires setting up a board of directors, maintaining corporate minutes, and holding annual shareholder meetings. More structure and regulatory requirements make S-Corps more expensive than LLCs. When establishing your S-Corp, you first register as either an LLC or a C Corporation and then elect S-Corp status. Some states allow S-Corps to be taxed as a pass-through entity (where income is taxed at the personal rather than corporate rate), but other states tax S-Corps the same as C Corps.
Which One is Better?
Whether your business should be an LLC or make an S-Corp election depends on a number of considerations. If you’re just starting out and your business is smaller with one owner, an LLC makes sense. As your LLC generates more income, your self-employment taxes will also increase, making an S-Corp more attractive. As mentioned above, S-Corp shareholders can share in company profits through dividends without having to pay self-employment taxes. The additional oversight required of S-Corps might also provide your business with more credibility, especially if you’re seeking outside investors.
However, S-Corporation shareholders must be paid “reasonable compensation” for the services they perform for the business. Also, more than 2% shareholders are not allowed to participate in tax-free employee benefits such as group health insurance or a cafeteria plan.
The Bottom Line
There’s not a one-size-fits-all answer to the appropriate entity for your organization. As your business grows and changes, today’s answer might not be the same in the future. It’s important to visit with your tax advisor before making any changes to be sure you understand the ramifications and are in compliance with all applicable regulations.