Starting and running your own business is a rewarding endeavor, but it comes with its share of complex decisions—particularly when it comes to choosing the right legal and tax structure. Among the most common choices for small business owners are Limited Liability Companies (LLCs) and S Corporations (S Corps). The Nakase law firm has helped countless entrepreneurs navigate these structural decisions with clarity and confidence, ensuring their businesses are built on a strong legal and financial foundation.
The key difference between an LLC and an S Corp is that an LLC is a legal business structure, while an S Corp is a tax classification that can be elected by eligible corporations or LLCs. While these two structures often appear to be alternatives, the relationship between them is more complementary than conflicting. Understanding how each works, the differences between them, and the implications for taxes and liability can significantly affect the success of your business.
Understanding the Basics: LLCs and S Corporations Defined
One of the most common misconceptions among entrepreneurs is that LLCs and S Corps are mutually exclusive options. In truth, they represent different aspects of your business structure.
An LLC, or Limited Liability Company, is a legal structure recognized by state governments. It provides limited liability protection, meaning your personal assets—such as your home, vehicle, and savings—are shielded from business debts and lawsuits.
An S Corporation, on the other hand, is not a type of legal structure but a federal tax election. It’s a status granted by the IRS that affects how your business income is taxed. This tax classification is only available to eligible domestic corporations and LLCs that meet specific criteria.
So in essence, you can have an LLC that is taxed as an S Corp. Forming an LLC provides legal protection, while electing S Corp status can potentially lower your tax liability.
How to Form an LLC or S Corp
To form an LLC, you must file articles of organization with your state and pay the applicable filing fee. You’ll also need to choose a unique business name and designate a registered agent. After completing these steps, your business becomes a separate legal entity.
To become an S Corp, you must first establish your business as a corporation or LLC under state law. Then, you must file IRS Form 2553, known as the “Election by a Small Business Corporation,” to request S Corp tax treatment. Your business must meet certain requirements, such as having no more than 100 shareholders and allowing only U.S. citizens or permanent residents as shareholders.
In most states, including Indiana, forming an S Corp legally mirrors the process of forming a C Corp. You file articles of incorporation and pay a fee, followed by filing the S Election with the IRS.
LLC vs. S Corp: Ownership and Eligibility Rules
One of the major structural differences between LLCs and S Corps lies in ownership rules.
An LLC offers maximum flexibility in ownership. Individuals, corporations, partnerships, and even foreign entities can be members. There’s no limit on the number of members an LLC can have.
An S Corp, however, is more restrictive. Only individuals who are U.S. citizens or permanent residents can be shareholders. Additionally, an S Corp can’t have more than 100 shareholders, and only certain types of trusts and estates are permitted to hold shares. Other corporations, LLCs, and partnerships cannot be shareholders in an S Corp.
These limitations make the S Corp less suitable for businesses seeking complex or international ownership structures but potentially advantageous for small, U.S.-based companies with relatively simple ownership.
Operational Differences: Formalities and Administrative Burdens
When it comes to daily operations, LLCs generally require fewer formalities. For example, in states like Indiana:
- LLCs are not required to hold annual meetings.
- LLCs don’t need to have corporate officers.
- Recordkeeping and reporting requirements tend to be more relaxed.
S Corps, by contrast, are expected to maintain more formal business operations. They must:
- Hold annual shareholder and director meetings.
- Keep corporate minutes and detailed records.
- Appoint officers such as a president, treasurer, or secretary.
These formalities can add complexity to your business management but also lend greater transparency and legitimacy, which may be advantageous if you seek investors or loans.
Key Taxation Differences Between LLCs and S Corps
One of the primary reasons business owners consider S Corp status is the potential for significant tax savings. Understanding how each structure is taxed helps clarify why this election can be so impactful.
By default, a single-member LLC is taxed as a sole proprietorship. This means the entire net income of the business passes through to your personal tax return. You’re responsible for paying:
- Federal income tax based on your tax bracket.
- A self-employment tax of 15.3% (covering Social Security and Medicare) on all business profits.
With an S Corp election, the business owner becomes both an employee and a shareholder. Here’s how that changes things:
- The owner pays themselves a “reasonable salary” that is subject to payroll taxes (Social Security, Medicare, FUTA).
- The remaining profits are treated as distributions, which are not subject to self-employment taxes.
- The business pays the employer share of payroll taxes (7.65%) on the salary, which can be deducted as a business expense.
This split can result in significant tax savings, especially when profits exceed what a reasonable salary would be for your role.
Tax Example: LLC vs. S Corp
Let’s look at an example:
- You earn $120,000 in revenue.
- You incur $20,000 in business expenses.
- Your net profit is $100,000.
As an LLC taxed as a sole proprietorship, you would pay self-employment tax on the full $100,000, in addition to federal income tax.
As an S Corp, if you paid yourself a reasonable salary of $50,000:
- You and the business would share payroll taxes on the $50,000 salary.
- The remaining $50,000 could be distributed to you as a dividend, free of self-employment tax.
- You would still owe income tax on the full $100,000, but you’d save significantly on payroll taxes.
Pass-Through Taxation and the QBI Deduction
Both LLCs and S Corps qualify as pass-through entities, meaning the business itself doesn’t pay federal income tax. Instead, profits are passed through to the owners’ personal tax returns.
One additional benefit is the Qualified Business Income (QBI) deduction, which allows eligible business owners to deduct up to 20% of their qualified business income. S Corps and LLCs taxed as sole proprietorships or partnerships generally qualify for this deduction, but income limits and industry-specific rules apply.
When an S Corp Is the Better Choice
S Corp status becomes especially beneficial when your business:
- Consistently earns more profit than what a reasonable salary for your work would be.
- Has low overhead, resulting in substantial net profits.
- Has a simple ownership structure with fewer than 100 U.S.-based individual shareholders.
Under these conditions, the ability to take distributions that are not subject to payroll tax can translate into thousands of dollars in annual savings.
When an LLC Might Be Preferable
Despite the tax advantages of S Corp status, there are scenarios where sticking with a standard LLC may be the better option:
- If your business is just getting off the ground and isn’t earning much profit yet.
- If you want to avoid the complexity of payroll, quarterly estimated tax payments, and additional administrative requirements.
- If you anticipate a more flexible or international ownership structure.
- If your state doesn’t recognize S Corp status, requiring separate tax filings at the federal and state level.
In such cases, the simplicity of operating as a traditional LLC may outweigh the potential tax savings.
Drawbacks of S Corps
While S Corps offer appealing tax benefits, they also introduce several drawbacks:
- You’re required to run payroll for yourself, including withholding taxes and making employer contributions.
- You must ensure that your salary is “reasonable” in the eyes of the IRS.
- There’s additional paperwork, including filing IRS Form 2553 and managing payroll reporting.
- You may need to file quarterly estimated taxes and state-specific corporate returns.
- Not all states treat S Corps favorably, which can result in inconsistent federal and state tax treatment.
Because of these complexities, many S Corp owners work with accountants or tax professionals to ensure compliance.
Disadvantages of LLCs Without S Corp Election
While LLCs are easy to set up and manage, their default tax treatment can lead to higher self-employment taxes. For businesses generating significant profit, failing to elect S Corp status can mean leaving substantial tax savings on the table.
For example, if you earn $100,000 and don’t pay yourself a separate salary, you’ll pay self-employment tax on the entire amount. By electing S Corp status and splitting that into a salary and distributions, only part of that income would be subject to payroll taxes.
Making the Switch: From LLC to S Corp
If you’ve already formed an LLC, switching to S Corp taxation is a relatively straightforward process:
- Ensure you meet eligibility requirements (e.g., 100 or fewer shareholders, all U.S. citizens or residents).
- File IRS Form 2553 to elect S Corp tax status.
- Begin running payroll and maintaining accurate accounting records.
- Consider using a payroll provider or accountant to simplify compliance.
Note that some businesses file the election at the time of formation, while others wait until their income justifies the added complexity.
Should You Convert Your LLC to an S Corp?
The decision to convert your LLC to an S Corp depends largely on how much your business earns. A common rule of thumb is:
- If your annual profit is less than $80,000, the tax savings may not outweigh the additional administrative costs.
- If your profit is more than $80,000 and your salary would be reasonably lower than that amount, the tax savings can be significant.
Before making the switch, calculate a reasonable salary for your industry and assess your typical profit levels. Many business owners also consult tax professionals to model the tax impact before filing.
Frequently Asked Questions
Who pays more taxes: LLCs or S Corps?
Typically, LLCs taxed as sole proprietorships pay more in self-employment taxes. S Corps allow some of the income to be distributed free of those taxes, leading to lower overall liability.
Why choose an S Corp over an LLC?
If you want to reduce your self-employment tax burden and are earning enough profit to make it worthwhile, an S Corp offers tax efficiencies that a traditional LLC doesn’t.
What is a reasonable S Corp salary?
The IRS requires that S Corp owner-employees pay themselves a “reasonable salary” for the work they perform. This should be comparable to what similar businesses pay for similar roles. Factors include your experience, time commitment, industry standards, and business profitability.
Do S Corp owners have to take a salary?
Yes. Owner-employees of S Corps are generally required to take a salary before taking any profit distributions.
How can I tell if my LLC is an S Corp?
You’ll need to have filed Form 2553 with the IRS and received confirmation of S Corp tax treatment. If you haven’t done this, your LLC is taxed as a sole proprietorship (or a partnership if it has multiple members).
What is the S Corp tax rate?
S Corps themselves do not pay federal income tax. Instead, profits pass through to the owner’s personal tax return and are taxed at individual rates. The effective tax rate depends on the owner’s income bracket.
Conclusion: Aligning Structure With Strategy
Choosing between an LLC and an S Corp isn’t necessarily a matter of one being better than the other—they serve different purposes. An LLC gives you legal protection and simplicity, while an S Corp adds a layer of tax optimization. In many cases, the best path is forming an LLC and then electing S Corp tax status once your business earns enough to benefit.
Ultimately, the right decision depends on your business’s financial profile, growth trajectory, and how much administrative complexity you’re prepared to handle. By understanding the nuances of each structure, you can confidently shape your business to support long-term success—legally and financially.
