S corporations and LLCs have much in common. They are both legal entities that are separate from their owners and thus offer limited liability protection. That is, the owners of an S corporation or LLC are not personally responsible for the business’s debts and liabilities. They are also both “pass-through” taxation entities, meaning no income taxes are paid at the business level; instead, profits or losses pass through to the owners’ personal tax returns.
While the difference between an S corporation and an LLC is often viewed as a matter of how the business is taxed, in general, neither option is inherently “better” than the other. The choice of whether to incorporate or form an LLC often depends on the business type, number of owners, types of owners, and size. Some key differences include:
- Number of Owners. S corporations are limited to 100 or fewer shareholders. In contrast, LLCs can have an unlimited number of members.
- Non-U.S. Citizens/Residents. S corporations cannot have non-U.S. citizens or residents as shareholders. This restriction does not apply to LLCs.
- Other Entities as Owners. S corporations cannot be owned by corporations, LLCs, partnerships, or many types of trusts. This restriction does not apply to LLCs.
- Classes of Owners. S corporations cannot have multiple classes of stock with different financial rights, such as preferential dividends or distributions. This restriction does not apply to LLCs.
- Subsidiaries. LLCs may have subsidiaries without restriction. S corporations are less flexible in this area.
- Allocation of Profits and Losses. S corporation shareholders receive profits and losses based on their ownership percentage. LLCs can allocate profits and losses on almost any basis agreed upon by the owners.
- Owners as Employees of the Entity. While both S corporations and LLCs are “pass-through” entities for income tax purposes, S corporations may, in some cases, offer advantages regarding self-employment taxes. An S corporation owner (shareholder) can be treated as an employee and paid a reasonable salary. While taxes, including FICA, are deducted from that salary, the remaining corporate earnings may be classified as unearned income and not subject to self-employment taxes.
- Management. S corporations are owned by shareholders, who elect directors to oversee corporate affairs and major decisions. Directors typically do not manage daily operations but instead appoint corporate officers to handle day-to-day business activities. LLCs, on the other hand, can be managed by their owners (members), operating more like a partnership, or by designated managers, allowing them to function more like a corporation.
- Ongoing Business Formalities. Although corporations are subject to more formal management rules than LLCs, and S corporations must follow more detailed procedures, most advisors recommend that LLCs adopt similar practices to ensure they operate as separate legal entities from their owners.
So, which one is right for you?
If you are forming a new business or reorganizing an existing one, you should meet with your team of advisors to review your current and future plans and determine the best choice.
