LLC vs. S Corporation: What’s the Difference?

Choosing a business structure is one of the first important decisions a new business owner makes. Two terms that often come up are LLC and S corporation, but they don't describe exactly the same thing.

An LLC is a type of legal business entity, while an S corporation is generally a federal tax election that eligible businesses can choose. Understanding that distinction can make it easier to evaluate which structure may fit your business.

What Is an LLC?

A Limited Liability Company (LLC) is a business structure created under state law.

LLCs are popular with small business owners because they can provide liability protection while offering flexibility in ownership, management, and taxation.

Depending on the number of owners and elections made, an LLC may be treated differently for federal tax purposes.

What Is an S Corporation?

An S corporation, or S corp, is a federal tax classification available to qualifying businesses that make the appropriate election.

An eligible LLC can potentially elect to be taxed as an S corporation, which is why comparing an “LLC vs. S corp” can sometimes be misleading. A business can actually be both an LLC and taxed as an S corporation.

The S corporation election changes how certain business income and compensation are treated for federal tax purposes.

How Are They Taxed Differently?

A single-member LLC is generally taxed as a disregarded entity by default, while a multi-member LLC is generally treated as a partnership unless another tax treatment is elected.

With an S corporation election, business income generally passes through to the owners and is reported on their individual tax returns.

An owner who works for an S corporation generally must receive reasonable compensation as an employee before taking additional distributions. This distinction can affect employment and self-employment taxes.

Why Do Some Business Owners Choose S Corporation Taxation?

For some profitable businesses, electing S corporation taxation may provide an opportunity to reduce certain employment-tax exposure compared with default taxation.

However, that doesn't automatically mean an S corporation is the better choice.

S corporations also introduce additional responsibilities that can include:

• Running payroll for owner-employees

• Filing a separate business tax return

• Maintaining appropriate financial records

• Paying reasonable compensation

• Following S corporation eligibility requirements

• Managing additional tax and administrative obligations

The potential tax benefit needs to be considered alongside these additional costs and responsibilities.

When Might an LLC Make Sense?

An LLC can be attractive to owners who want a relatively flexible business structure with liability protection.

For a new or smaller business, keeping the default tax treatment may also be simpler than immediately making an S corporation election.

As the business becomes more profitable, the owner can discuss whether another tax classification may become advantageous.

Can You Change Later?

In many situations, an LLC can begin with its default federal tax treatment and later elect S corporation taxation if the business qualifies.

That means owners don't necessarily need to make every long-term tax decision on the day the business is formed.

However, tax elections have requirements and deadlines, so planning before making a change is important.

Which Is Right for Your Business?

There is no universal answer.

The appropriate structure can depend on factors such as:

• Expected business profit

• Number and type of owners

• How owners work in the business

• Payroll requirements

• Administrative costs

• Tax considerations

• Long-term plans for the company

Rather than choosing a structure based only on what another business owner uses, consider how each option applies to your specific circumstances.

Start Your Business With the Right Foundation

Your business structure can influence taxation, payroll, reporting, and administrative responsibilities for years to come.

James Ridout CPA provides business formation guidance, entity selection assistance, S corporation tax planning, EIN assistance, bookkeeping, and ongoing small business accounting support.

Starting a business or considering an S corporation election? Schedule a consultation with our team.