Home > Startup > Making Your Business Official > Choosing Between an LLC vs. S-Corp – Pros and Cons

Choosing Between an LLC vs. S-Corp – Pros and Cons

By: Martin Eckler

 

pros and cons of LLC

Starting a business comes with many tasks to handle and many decisions to make. In the early stages, one of those decisions is the type of business entity to form. You’ve probably heard of the most popular, but you’ll still have choose between an LLC vs. S-Corp, both of which have pros and cons.

Here we’ll detail what both of those are, and the pros and cons of each.

What Is an LLC?

An LLC is a common business entity choice for new entrepreneurs because of the benefits it offers. Unlike sole proprietorships or partnerships, an LLC is a separate entity from its owners, called members, and can thus have its own assets and debts. This means that the LLC members do not have personal liability for the obligations and debts of the LLC.

An LLC also offers pass-through taxation, meaning that the LLC is not taxed. Profits instead pass through to the members to be reported on their personal tax returns and taxed at their personal tax rates. This differs from a corporation, which is a taxable entity. Dividends paid to owners, called shareholders, are also taxed, which is commonly referred to as double taxation.

LLCs are also much simpler than corporations with few management and administrative requirements. Members are free to structure their management in any way they choose.

What Is an S-Corp?

A common misconception is that an S-Corp is a type of business entity. It’s actually a tax status that an LLC or a corporation can elect if it meets certain requirements.

When an LLC has S-Corp status, it must meet the requirements of a corporation, which include electing a board of directors and appointing company officers. Member ownership is no longer measured in percentages but instead as a number of shares.

With S-Corp status, however, the LLC is still a pass-through entity and not subject to corporate taxes. But managing shareholders must be paid a reasonable salary before taking any profit distributions.

That salary is subject to regular employment taxes, but the profits remaining after expenses and salaries are not subject to self-employment taxes.

On the other hand, in an LLC without S-Corp status, members pay self-employment taxes on all the profits of the LLC.

S-Corp status can provide members with self-employment tax savings, and the LLC remains a pass-through entity not subject to corporate taxes.

So, the main differences between an S-Corporation and an LLC are the corporate and salary requirements and the self-employment tax liability.

To qualify for S-Corp status, the LLC has to  meet the following requirements:

  • Be a domestic corporation
  • Have only allowable shareholders
    • May be individuals, certain trusts, and estates and
    • May not be partnerships, corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

To elect S-Corp status, you simply need to file Form 2553 with the IRS.

LLC vs. S-Corp: Pros and Cons 

Pros and Cons of not electing S-Corp status

Pros

  •         No corporate requirements
  •         No salary requirements
  •         Lower administrative expenses

Cons

  •         Self-employment tax liability on all profits
  •         Unlike C corporations, which can retain earnings for future growth, LLC members must pay taxes on their share of profits, even if they choose to reinvest them in the business.

Pros and Cons of S-Corp Status

S-Corp status also has pros and cons.

Pros

  •         Maintain pass-through taxation
  •         Self-employment tax savings
  •         S Corp owners may have the opportunity to contribute to retirement plans like a 401(k) or SEP IRA, potentially saving on taxes while saving for retirement.

Cons

  •         Meet corporation administrative requirements
  •         Salary requirements
  •         Additional administrative and payroll expenses
  •         Increased IRS scrutiny

Making the Choice of LLC vs. S-Corp

Determining whether S-Corp status is right for your business is a complex process, but essentially it comes down to the additional administrative requirement and expenses, and the self-employment tax savings.

For S-Corp status to be financially beneficial, the self-employment tax savings must be greater than the additional administrative expenses. You also have to be prepared to handle all the additional management requirements and complexity of an S-Corp.

The decision is best made with the help of a tax advisor who can handle the complex calculations involved.

What If Members Don’t Agree About the Choice?

Since the tax status decision for an LLC is complex, there is the possibility that members will not agree. That’s why it’s important for your LLC to have an operating agreement.

The operating agreement defines the ownership percentages of members, how profits are allocated and distributed, the management structure of the LLC, member and manager roles and responsibilities, voting rights of members, and more.

It should also have provisions regarding how disputes are resolved, so if members do not agree about the tax status of the LLC, the operating agreement can provide resolution. Usually, such decisions require a majority vote based on the voting rights of the members.

You should have your operating agreement in place from day one, so that dispute situations don’t end up in court. It’s best to have an attorney’s help when determining the terms of your operating agreement.

In Closing

An LLC is a smart choice for business owners because of the many benefits it offers. Electing S-Corp status for your LLC can also be beneficial in some situations. Again, when making the choice, it’s crucial to have a tax advisor involved to help you weigh the pros and cons and to make the calculations involved.

Published: August 29, 2023
627 Views

Trending Articles

Stay up to date with
martin eckler

Martin Eckler

Martin Eckler is a legal advisor for Stepbystepbusiness, a proud team of serial entrepreneurs and business writers. They aim to help new business owners with their experience and free online guides, to spread the word to a broad audience of entrepreneurs.

Related Articles