One of the most common questions people ask when deciding to incorporate is what is the difference between an LLC and S-Corp? Incorporating as an S-Corp or forming your company as an LLC can provide distinct advantages for you and your business. They both can give you some measure of personal liability protection, and both can help to raise your perceived legitimacy in the eyes of investors. The tough question is: How do you know which business entity to choose? Although some companies choose to become C-Corps, partnerships, or non-profits, for many small business owners and freelancers, the choice generally comes down to LLC vs. S-Corp. We have broken each option down to help you determine which might be the best for you and your business.
Why form an LLC?
LLCs or Limited Liability Companies can be a bit easier than an S-Corp to start and to run, and generally, they can take less upkeep to remain compliant. Some distinct advantages of starting an LLC are:
In general, this means that members are not personally liable for debts and (often) court judgments incurred by the LLC. This can be a meaningful shield not provided in a sole proprietorship or traditional unincorporated partnership.
The IRS does not consider an LLC to be a distinctly separate entity for tax purposes. This means that the IRS will not tax the LLC directly for business income. Instead, members of the LLC get to determine how they want to be taxed. There are several options:
- Single member LLC: This structure is taxed like a sole proprietorship. Income from profits or losses from the business are not taxed directly, but instead, are taxed through the single member’s personal federal tax return.
- Partners in an LLC: Members elect to be treated like a traditional partnership for tax purposes.
- Filing as a Corporation: The members of the organization may also choose to file as if they were a corporation.
Generally, members of an LLC will create an Operating Agreement that outlines how the LLC will be treated for tax purposes.
There is less paperwork up front and in the long-term
Compared to S-Corps, LLCs are very flexible. With fewer requirements for compliance and less necessary paperwork, LLCs are generally easier to form and easier to keep in good legal standing. You will want to have an LLC Operating Agreement, so you can create rules that govern your business. Otherwise, your company will be governed by the default rules in your state.
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Why form an S-Corp?
The largest and most profitable companies in America are generally classified as corporations—either as S-Corporations (S-Corp) or C-Corporations (C-Corp). An S-Corp is a corporation where income from the corporation is passed through as personal income (no separate tax return is filed). Some potential advantages to an S-Corp are:
Liability protection for shareholders
Only the money invested in the S-Corporation by its shareholders is at risk, barring extreme circumstances. Personal assets are usually protected, as they are with LLCs.
S-Corps are not taxed, but shareholders are
In other words, if your S-Corp is made up of four partners and your company made $40,000 this past year, you might each claim $10,000 in taxable income from your S-Corp. While your S-Corp will need to file an IRS 1120 S form, S-Corps are considered “pass-through entities”, much like LLCs are, and are not taxed, in and of themselves.
S-Corps have a more rigid management structure
All S-Corps have hard and fast rules for how to remain compliant, who can vote on corporate practices, etc. These rules give shareholders and owners a real, clear path to follow, and that path is familiar to investors.
S-Corps require more paperwork
This may seem like a disadvantage, but the additional paperwork actually gives you a concrete record of your decisions and proof that you acted in the best interest of your company. While this can feel tedious, having these documents can be very valuable for tax and liability purposes.
S-Corps can sell stock
To raise capital, corporations often sell stocks. LLCs can only sell interests in their company.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.