LLC vs S Corp (What's the Difference?) - MarketWatch (2024)

Updated:Jun 29, 2024

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An LLC, short for “limited liability company”, is a type of business entity that combines the tax benefits of a partnership or sole proprietorship with the liability protection of a corporation. This blend of business structures is a popular choice for small business owners and startups because it has the advantages of being a big business without the required corporate formalities. You can start your own LLC by filing articles of organization with your state’s secretary of state or corporations division.

A common misconception about S-corporations is that they are a type of business entity, like a corporation (also known as a C-corporation or C-corp). However, an S-corp is not a business entity type at all. It’s a tax classification created by Subchapter S of the Internal Revenue Code to allow business owners to treat taxable business income differently. Certain businesses can apply for S-corp status by filing Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service (IRS).

Since S-corps and LLCs are not mutually exclusive, you’ll see a lot of similarities between the two in practice.

Personal Liability Protection

S-corp election has no effect on your liability protection. Whether you’re forming an LLC or an S-corp, your personal assets will be protected from any claims that arise from your business.

Pass-Through Taxation

Both LLCs and S-corps are considered “pass-through entities” for federal tax purposes and therefore enjoy pass-through taxation. This means the corporate tax passes through the entity and lands on the owners of an LLC or S-corp. You’ll then have to claim any corporate income on your personal income tax return at the end of the tax year. S-corps, LLCs, partnerships and sole proprietorships are all pass-through entities.

This is preferable to the C-corp tax status which suffers from double taxation. Double taxation is when your business profits are taxed both at the corporate level and the individual level. Specifically, the business will pay a corporate tax on its total income and the shareholders pay taxes on any dividends received when they file their personal tax returns.

LLCs are created under and governed by state law. S-corps, on the other hand, are created by the IRS and therefore governed by federal law. This leads to a few differences in how they operate.

Ownership Structure

If you elect for S-corp tax status, you’ll have to adhere to certain corporate formalities that other non-S-corp LLCs are not subject to. For example, S-corps can’t be owned by more than 100 shareholders, non-U.S. citizens or any other type of legal entity (e.g., corporations, LLCs, partnerships, trusts, etc.). LLCs have no such restrictions.

Management Structure

LLCs enjoy more flexibility in their management structure than S-corps. For example, LLCs may choose to be member-managed or manager-managed, while S-corps must be managed by officers and a board of directors. This may affect how you want to structure your business because you’ll likely be less involved in daily business decisions by creating an S-corp.

S-corporation status requires you to adhere to corporate formalities that other LLCs are not subject to. For example, S-corps must have corporate bylaws as well as regular shareholder and director meetings. LLCs are still recommended to have regular meetings for members as a good business practice, but there’s no requirement.

Profit Sharing

A key distinction here is that LLCs are far more flexible in how members share company profits. In an LLC, you can dictate the percentage of profits each member is entitled to using the operating agreement. However, an S-corp may still lead to more tax savings than a regular LLC.

S-corps must adhere to restrictions on how profits can be distributed to the shareholders. However, distributions made from an S-corp, known as “dividends,” are not subject to a self-employment tax. Be careful — this doesn’t mean you should only take distributions from your S-corp. You’ll have to take a “reasonable salary” for your work which is subject to the self-employment tax. Failing to take a salary in line with market standards can result in hefty penalties.

When it comes to cost, there are notable distinctions between LLCs and S-Corps. S-Corps typically entail higher initial and ongoing costs due to more formal administrative requirements, such as the need to maintain regular meetings, adopt corporate bylaws, and issue stock certificates. Additionally, S-Corps may face additional compliance expenses for federal and state taxes. On the other hand, LLCs often have lower upfront and ongoing costs, as they generally have fewer formalities and paperwork requirements. While both entities may have their associated costs, the decision between an S-Corp and an LLC should be based on various factors including the business’s financial situation, operational needs, and long-term goals.

S-corps are best suited for more experienced business owners because of the strict requirements that apply to them. LLCs that are controlled by multiple members may have an easier time converting to an S-corp because they require a board of directors. Choosing an S-corp will help you save on your self-employment taxes, just be aware that this will require intense and precise bookkeeping.

LLCs are best suited for smaller businesses because of their flexibility, cost and convenience. LLCs require far less paperwork to both create and maintain than an S-corp. LLCs will also offer members more flexibility in terms of ownership, management and profit sharing since almost everything can be determined by the LLC’s operating agreement. While the tax benefits may not be as advantageous as with an S-corp, an LLC does still avoid corporate taxes while shielding you from liability.

Remember, if you choose to create an LLC instead of an S-corp, you can always elect S-corp tax status down the road by simply filing a form with the IRS.