An S corporation is not a type of business entity, but rather an IRS tax classification. A limited liability company (LLC) can choose to be taxed as an S corporation or as a default LLC. Some businesses choose to be taxed as an S corp as they are then given tax benefits. There are however certain requirements that need to be taken into account when you are deciding whether to be taxed as an S corporation vs LLC.
Table of Contents
What is An S corporation?
An S corporation is a small, closely-held corporation. It is also a tax election that lets the IRS know your business needs to be taxed as a partnership. It prevents your business from incurring corporate-level double taxation.
In an S-corp, the business owners are known as shareholders. As an owner, you are considered an employee of the business and must pay yourself a reasonable salary. To determine what a reasonable salary for your position would be, you can compare similar salaries on websites like Glassdoor or the US Bureau of Labor Statistics.
FICA taxes are taken out and paid on the amount of the salary. Corporate earnings after salary may be able to be treated as unearned income that will not be subject to self-employment taxes. An S-corp’s profits, losses, deductions, and credits are taxed at the shareholder level.
To be accepted as an S corp the business needs to have no more than 100 shareholders (and those shareholders can’t be partnerships, corporations, or foreign nationals). The business must also have only one class of stock and must complete any additional corporate formalities and procedures required under state law.
What is A Limited Liability Company
An LLC is a business structure that protects the personal assets of the business’s owners. If the business gets involved in legal troubles or is charged with a lawsuit, the plaintiff or creditor can only go after the business’s assets, not the personal assets of the LLC members.
LLC’s allow for pass-through taxation, which is beneficial for most business owners as they will not have to file a corporate tax return. An owner must simply report their share of profit and loss on their individual tax return. This prevents double taxation, your business paying taxes, and you paying taxes. In an LLC, the business doesn’t pay any taxes, only the owner.
LLC vs S Corporation
In general, both LLCs and S corps are subject to “pass-through” taxation. For S corps, income tax responsibility flows through the corporation to the shareholder and shows up as income on their taxes. For this reason, S corporations aren’t subject to corporate income tax. Instead, the shareholders report income and losses on their personal tax returns and are assessed at their individual income tax rates.
Most small businesses use the default LLC tax classification to file their taxes. This is because small businesses don’t usually carry over the amount of profit required to make the S corp tax designation beneficial. It only makes sense to file taxes as an S corp if there is enough profit carried over from year to year to pay owners a reasonable salary and substantial distributions.
From a tax perspective, it makes sense to convert an LLC into an S Corp, when the self-employment tax exceeds the tax burden faced by the S Corp.
The following criteria determine whether electing the S corp tax classification makes sense for an LLC:
- The LLC business owners must earn a “reasonable salary”.
- The business should consistently earn a substantial profit and pay distributions.
- The tax advantage must counterbalance the cost of maintaining the S corp.
- The business must meet S corp requirements of the IRS.
For most business owners filing your business under the LLC entity would be the best option, with regard to tax returns. It would only really make sense to convert to an S-Corp once you’re earning a meaningful amount of money.