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LLCs are a popular way for businesses to be taxed and manage their finances, but they’re not the only option available. S corporations allow small-business owners with low revenues to pass tax savings on to shareholders who can then pay taxes at individual rates.
Plus, LLC taxes can’t be passed on by dividends, which makes them less flexible than S companies; without an immediate liquidity event like an initial public offering or sale of stock in the company.
A Liability is limited company (LLC) is a low-maintenance legal organization that is ideal for a small business. S corporations are intended to help business owners save money on taxes.
LLCs are a more intricate legal form that is suitable for companies who want to maintain their revenues.
We’ll break down and explain these company formats in as much detail as possible, providing facts that each small business owner should be aware of.
Before we get into the differences between LLCs, S-corps, and C-corps, here’s a quick rundown of the three company structures and what they do:
What Is an S-Corporation, Exactly?
We’ll start with a definition of the S-corporation, which is technically not a corporate structure but rather a tax status. The S corporation, often known as the small business corporation, was founded by Congress in 1958 to provide smaller firms with comparable tax benefits to corporations without double taxation.
S-corporation is not a company structure, contrary to popular belief. It’s a tax status, which is also known as a tax classification.
To get the S-corp tax status (which has many advantages that we’ll go through below), you must first register as an LLC or C-corp with the state where you perform most of your business. Then, after you’ve registered, mail Form 2553 to the IRS indicating that you’d prefer to tax your company as an S-corporation.
What makes things more complicated is that many online legal firms claim to register your company as an S-corp, but this isn’t always the case. You choose an LLC or C-corp and then designate (also known as “elect” in tax jargon) that firm as an S-corp for tax reasons.
S-corporation is a federal (IRS) classification, not a state one. Don’t be shocked if you don’t notice any information on S companies while registering your firm with the state, whether it’s an LLC or a C corporation.
You may be asking why you’d want to convert your LLC or C-corp to an S-corp for tax purposes. It all boils down to tax reduction.
Why choose the S-corporation tax status?
Assume your company is a Liability is a limited company (LLC) with a net profit of $75,000 (profit after expenditures are deducted), you’ll have to pay a self-employment tax of 15.3 percent, or $11,475.
If your company were an LLC, you’d have to pay $11,475 in taxes on a $75,000 net profit.
If your LLC were to be converted to an S-corp, the financial situation would be quite different. As an S-corp, you may reduce your tax liability by paying a dividend. A dividend is money that would be left over if you paid yourself a “fair” wage in the company. It’s a bit tricky to figure out your company dividend but bear with me.
Consider the following scenario:
How much would you get paid in another comparable firm for the job you’re now doing? Let’s pretend that an owner would pay you $45,000 to conduct a similar work at a similar firm.
Some say that a company owner cannot be compared to another management position. The IRS, on the other hand, is unconcerned with that argument. To figure up a payment, use your common sense.
Returning to the example, take your $45,000 “fair” compensation and subtract it from your $75,000 net income, leaving you with a dividend of $30,000. What’s fantastic about the S-corp is that you don’t have to pay taxes on this dividend, which saves you $4,590 in taxes in this case. That’s a significant sum of money merely to switch your tax status to an S-corp!
What is the Best Business Structure for You?
When Should You Use an LLC Instead of an S-Corporation?
Why would someone pick an LLC over an S-corp if an S-corp helps a firm save money on taxes? You can’t save money on taxes if your salary is the same as or less than what you might earn in a comparable position at another firm.
For example, if your net profit is $40,000 and you make $40,000 as “fair” pay for the work, you might simply keep your LLC status and avoid the S-corp tax status.
One disadvantage of forming your company as an S corporation rather than an LLC is that it requires more paperwork. Your taxes are also a bit more difficult. Schedule K-1s must be included in your business tax filings, and you may require the help of a tax specialist.
You’ll also need to set up payroll via an S-corp. Every month, you must record paying yourself a wage and deducting self-employment taxes.
Many company owners, such as freelancers, select the LLC to avoid this extra effort for the sake of simplicity.
Advantages of a Liability Limited Company
- Asset protection for individuals
- There will be less paperwork.
- There are no restrictions on the number of people who may
Disadvantages of a Liability Limited Company
- All net earnings are subject to taxation.
- Raising outside finance is a difficult task.
- If a member quits the LLC, it will be dissolved.
Advantages of a C-Corporation
Why would anybody want to register their firm as a C-corporation, particularly given the S-tax corp’s advantages?
One of the major reasons a company becomes a C-corp is to save money on taxes, but this time in a different way. All revenues from an LLC or S-corp are distributed. Profits may be held inside the company with a C-corp.
For example, if your company makes $100,000 in net profit, you might pay yourself $75,000 and keep the remaining $25,000 (also known as “retained profits”). The retained profits are tax-free and maintained in a separate account.
A company’s net value rises as retained profits accumulate. For example, before COVID-19, Apple had been profiting at roughly $80 billion per year for the previous five years.
A legal obligation may also compel a company to become a C corporation.
When is a firm necessary to be a C-corporation?
- There are over 100 stockholders.
- Shareholders from other countries
- As a shareholder, you might join a Partnership or another company.
- Stocks are divided into many categories.
- A few institutions (insurance and financial companies)
Advantages of a C-Corporation
- Liability is limited.
- Profits may be kept in the firm without being taxed.
- Without the original proprietors, the corporate entity will continue to exist.
- Attractive to investors
- There are no restrictions on the number of stockholders.
Disadvantages of a C-corporation
- Taxation is done twice (at the corporate and individual level)
- The board of directors meets once a year.
- With the help of a CPA, it may be more costly.
How to Form a Legal Entity and an S-Corporation
Visit your state’s official business registration website to register any of the lawful business entities. A company registration price may range from $40 in Kentucky to $500 in Massachusetts.
If your state’s registration website is difficult to browse, you may register your company through an online legal service. IncFile will compile and submit your company registration documents to your state for free, plus any applicable state costs. They provide the most cost-effective company registration service.
Consider employing a legal service like Rocket Lawyer if you have a legal matter and don’t want to pay the hefty fees of a local business attorney. For $49.99, you may ask an attorney a single question, or for $39.99 per month, you can ask an unlimited number of questions.
Local business attorney: You should engage a local business attorney if you’re starting a difficult company, such as an investor-ready C-corporation. It’s also a good idea to establish a working connection with a local attorney so that you can rapidly settle any legal difficulties.
Alternatives to LLCs, C-corporations, and S-corporations
You may decide after reading this tutorial that an LLC and a C-corp are not the best business structures for your company. Perhaps you reside in Massachusetts, operate a little side company (that is unlikely to be sued), and refuse to pay the $500 business registration cost. That’s a substantial sum of money.
A sole proprietorship is a business that is owned and operated by one person or a Partnership. Both company formations are free, but you may have to pay the state for a fake name (also known as doing-business-as).
A sole proprietorship
While we don’t generally recommend the sole proprietorship, I wanted to discuss it briefly, so you understand what it is and why it’s a legal structure.
If you don’t register your business in the state it’s doing business in; it’s by default a sole proprietorship. Business owners choose to stay as a sole proprietorship if they have a low-liability business (unlikely to be sued) and to avoid the fee to register the business.
The main downside of a sole proprietorship is that if a customer were to ever sue the business, your personal assets are at risk. What does that mean exactly? If a judge rules your business at fault, then the judge could order the liquidation of personal assets or garnish wages to pay damages.
Registering an LLC or corporation is a crucial legal step since it retains the liability for any damages incurred as a result of a lawsuit inside the company.
If you are keeping your business a sole proprietorship, you may need a doing-business-as (DBA) or also called a fictitious name. If you’re operating under any business name other than your legal name, you will need to register that business as a DBA with the state.
Partnership
A Partnership is similar to a sole proprietorship, except that it involves several owners. It is the default business structure for two or more owners that don’t register as an LLC or C-corp. Similar to the sole proprietorship, if a customer or vendor were to sue the business, all partners’ personal finances are at risk.
We strongly advise you to draft a partnership agreement if you are establishing a partnership. This agreement guarantees that you and your partner both understand what will happen to the company in the event of a tough scenario, such as incapacity to perform or prolonged time away from the firm.
Conclusion
The majority of small company owners will form an LLC. If a business owner feels that deciding to be an S-corporation would save them money on taxes, they will do so.
If a company makes a lot of money and the owner wants to retain a share of it, or if they want to seek money from an investor, they should consider becoming a C-corp.
If your company’s legal entity requirements are more sophisticated, consult an expert, such as a business attorney or a CPA (certified public accountant).
Frequently Asked Questions
Is LLC or S Corp better?
A: LLC is the better option for a sole proprietorship, but if you plan on hiring employees or have any other business entity beyond your personal ownership then it would be S Corp.
Should my LLC be an S Corp?
A: If you are a sole proprietor, then your LLC should be an S Corp.
Is my LLC an S or C Corp?
A: Your business is an outgrowth of the original LLC, which was a limited liability company. This means that you are not personally liable for any debts or damages incurred by your business should it go bankrupt and be unable to pay its creditors.
