Are you feeling stuck on what business structure to choose for your new venture? You’re not alone! Making these decisions isn’t easy, but it’s just a part of the process. Also, have you read our 'How To Become An Entrepreneur' article? Thankfully, we are here to give you all the information you need to make the best decision for your business - find out more about top business ideas here. Today we are talking about two options: S corporations and LLCs.
What Is an S Corp?
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Instead of the corporation paying taxes directly, the individual shareholders of the corporation report income and losses on their personal tax returns and then pay taxes on that income according to their personal income tax rates. This advantageous setup allows S corporations to avoid double taxation -- where you’re taxed both on the corporate and personal level. Additionally, you can check out our thorough guide on taxing of business structures and finding the best possible form for your company, and look here for the best bank to put your trust in.
However, along with this huge tax advantage comes additional restrictions. Not just any business can qualify as an S corporation. Instead, you have to meet certain requirements. For example, your business must be based in the United States and be considered a domestic organization. Additionally, you must have no more than 100 individual shareholders that are all U.S. citizens who pay federal taxes. Finally, you can only have one class of stock.
If you meet these requirements and want to establish an S corporation, after filing your Articles of Incorporation, you must file additional paperwork with the Internal Revenue Service, namely Form 2553. Also, bear in mind that with a decreased tax burden often comes increased tax scrutiny from the Internal Revenue Service.
What Is an LLC?
Another business structure to consider is that of a limited liability corporation or an LLC. This business structure allows owners to protect themselves from personal liability related to the business. For example, say the company goes bankrupt -- this would not affect the owners’ personal finances. By separating business assets and personal assets, owners are considered to be completely separate from the business itself.
However, not all types of businesses can become an LLC. For example, banks and insurance companies generally aren’t able to become an LLC. That being said, exact rules and regulations regarding LLCs exist at the state level and tend to vary from place to place -- so be sure to check the statutes in your specific state if you’re interested in forming an LLC.
Like S corporations, LLCs do not pay taxes at the corporate level. Instead, they pay pass-through taxes on the part of members. Additionally, LLC members are considered by the IRS to be self-employed and are required to pay additional taxes towards Social Security and Medicare when they file their personal income tax returns each April.
Similarities and Differences Between the Two
If you’re choosing between an S corporation and an LLC, you need to fully understand the similarities and differences between the two in order to make the best decision to meet your business goals:
In terms of membership, there are restrictions for S corporations in that you can only have 100 shareholders that must be U.S. citizens. On the other hand, LLCs can have an unlimited amount of shareholders that do not have to be U.S. citizens or residents.
In terms of ownership, S corporations cannot be owned by corporations, LLCs, partnerships, or many trusts. LLCs, on the other hand, have more flexible ownership options.
In terms of setup, S corporations can only have one class of stock, whereas LLCs are not subject to that restriction.
In terms of organization, S corporations are required to adopt bylaws, issue stock, hold initial and annual director and shareholder meetings, and keep meeting minutes. LLCs don’t have the exact organizational requirements. Instead, they just have recommendations that include things like adopting an operating agreement, issuing membership shares, holding and documenting annual member meetings, and documenting all major company decisions (find out more about LLC membership in this guide).
In terms of taxes, S corporation owners are considered employees and are paid a salary where taxes are automatically taken out. LLC owners, on the other hand, are considered self-employed and are required to pay additional taxes towards Social Security and Medicare.
Despite these differences, there are also some similarities between S corps and LLCs that you need to be aware of:
- Both S corporations and LLCs provide limited liability protection wherein owners are not personally responsible for business debts and other liabilities. As a result, personal assets and properties are protected.
- Both S corporations and LLCs are considered separate legal entities from that of the owners based on state filings.
- Both S corporations and LLCs are considered pass-through tax entities wherein they are not taxes at the business level, only at the individual level.
- Both S corporations and LLCs are subject to state compliance requirements. While some of the exact requirements may differ, both are required to appoint and maintain a registered agent, file annual reports, pay annual fees, and notify the state of any company changes.
Other Business Structures to ConsiderIn addition to S corps and LLCs, there are other business formations that you can consider when starting your business:
Sole proprietorship: This business setup allows an individual to set up a business completely on their own -- no paperwork required! This setup gives little designation or separation between the individual and their business. As a result, sole proprietors are vulnerable to things like debts and lawsuits that stem from their business. As a result of its straightforwardness and simplicity, this business setup is ideal for one-person operations or freelancers.
Partnership: This business setup allows two or more individuals to start a business as partners. Partnerships are ideal for starting a business with multiple equal owners, such as a law firm or a medical practice. There are two different types of partnerships: limited partnerships (LP) and limited liability partnerships (LLP). Limited partnerships or LPs feature one general partner that has unlimited liability while the other partners have limited liability. Limited liability partnerships or LLPs provide each partner with limited liability that protects their personal assets and information from business issues like debts and lawsuits.
C Corporation: This business setup allows owners to be separate from the business in every way -- including when it comes to taxes. As a result, C corporations are taxed once at the corporate level, and shareholders are taxed again on personal income earned from the corporation. When you file Articles of Incorporation to form a business, you’re automatically considered a C corporation. This business setup also allows you to sell your stock, grow your business beyond 100 shareholders, and potentially sell your business to another company
Cooperative: This business setup allows its members to elect a board of directors and officers. Members are also able to vote on things related to the cooperative, and all have an equal voice. As a result, members typically benefit directly from the services of the cooperative.
Which Option Is Better for Your Business?
With all this information in mind, it’s time to nail down the final details to help you make the best possible decision. Here are some additional things to keep in mind when choosing between an S corporation and an LLC:
Generally speaking, an LLC is a better option for single-owner businesses or partnerships since it is easy to form and doesn’t come with a whole host of additional requirements and intricacies.
An LLC is also a better option if you’re looking to keep your business relatively small and don’t anticipate taking it public or needing sizable outside investments.
As your business grows, it may make sense for you to switch to an S corporation to avoid hefty self-employment taxes since you’re now technically an employee of the corporation.
An S corporation also makes sense for larger businesses that have less than 100 shareholders. This option can also promote more involvement than other options with unlimited membership.
Overall, in most cases, it makes sense for a new business to start off as an LLC to maintain simplicity and flexibility within the business. As the business grows and goals change, you can always transition to an S Corp or another business format. Of course, you can always opt to buy an already existing business, as explained here.
Hopefully, with this information in mind, you can choose the best possible setup for your business to promote future success. However, if you’re still feeling lost or confused about all these unfamiliar business terms and tax lingo, feel free to reach out to the business experts at Matcha Business LLC.
Matcha Business LLC knows all about business, dealing with everything from small business financing to accounting woes. As a business owner, you often need to be a jack of all trades but don’t bite off more than you can chew by going it totally alone. We are here to help!