LLC vs. S-Corp: What is the Difference?

If you’re starting a business, one critical decision is which type of business entity to form. Limited liability companies (LLCs) and corporations (S-Corp) are two of the most common options. Both offer benefits and disadvantages, laid out for you in this handy guide.

What Is an LLC?

An LLC is a popular business structure for startup companies due to its many benefits. An LLC provides personal liability protection, for example, so that your assets are not at risk if your business is sued or cannot pay its debts. 

Also, an LLC is a “pass-through entity” in taxes, meaning that the LLC itself is not taxed. Instead, income passes through the company to the LLC owners or members, who report it on their tax returns on Schedule C. 

LLCs also offer flexibility in management, as there are few requirements regarding organizational structure. 

What Is a Corporation?

A corporation is a bit more complex than an LLC, with more formal requirements. For example, a board of directors must strategically implement the company’s business plan. 

Shareholders rather than members own a corporation. The ownership is in the form of shares of common stock. Shareholders have ownership of the company but no financial obligations to the company; however, they benefit from the profits of the company.

Unlike LLCs, a corporation pays taxes on the profits of the company. Shareholders also pay taxes on the dividends they receive from the company, which is known as double taxation. 

LLC vs. S-Corp

Let’s compare the elements of an LLC and an S-Corp to see how they are similar and different.

Ownership

LLC owners are called members. Their ownership percentages are defined in an operating agreement, specifying profit and loss distribution and member roles and responsibilities. The operating agreement should also define how ownership is transferred if, for example, a member leaves the LLC. 

The owners of a corporation are shareholders. The number of shares defines their ownership share in the company. They may also receive dividends from company profits.

The shares of a corporation are easily transferred, making a corporation more desirable to investors, who can take partial ownership in the form of shares in exchange for their investment. This is one of the main reasons entrepreneurs choose to form a corporation rather than an LLC. 

Administration

LLCs are easier and less expensive to form than a corporation. Unlike corporations, LLCs are not required to have a board of directors or hold annual meetings. LLCs do, in most states, have to file annual reports. Corporations are more complicated.

Control

In an LLC, the members do not have to answer to anyone. Instead, they fully control the company and can structure the management in any way they choose. In a corporation, on the other hand, managers answer to the board of directors, which has overriding decision-making power. 

Limited Personal Liability

In  LLCs and corporations, owners are considered separate entities from the business, so both structures offer personal liability protection. However, in a few instances, owners do have personal liability. For example, if an owner personally guarantees a bank loan, which is common, they’re liable for that debt. 

Taxes

As mentioned above, LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership. 

However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.

For corporations, the business income is taxed at the current rate for corporations (21% as of early 2022), which is lower than the usual individual taxpayer rate. But remember that corporation shareholders must also pay taxes on their distributions. 

However, members are subject to self-employment tax in an LLC taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply. 

Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status. 

With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses. 

Profit Sharing

No matter the entity type, most businesses split profits based on owners’ capital contributions. Corporations pay dividends based on the ownership percentage of the shareholders. 

With an LLC, on the other hand, owners can specify in the operating agreement any profit-sharing plan they choose. As a result, one member can take a share of profits greater than their ownership interest, while other owners take less. This may be based on the fact that one member is more involved in day-to-day operations.

Deciding Which Entity Type is Right for Your Business

Many entrepreneurs form an LLC because of its many benefits and simplicity. An LLC is often the best choice if you’re the only business owner, an LLC is often the best choice. If, however, you are in a high-growth industry and plan to raise money from investors soon, a corporation will make your business more attractive to those investors since shares can be easily transferred. 

Usually, small businesses that don’t plan to raise investment capital choose an LLC to avoid the double taxation of a corporation. 

Can a Corporation Own an LLC?

The most common scenario for a corporation owning an LLC is when the corporation is a holding company to own other businesses. A holding company, or parent company, is a business entity with no business operations. 

Instead, it maintains a controlling interest (more than 50%) in a company or companies, often known as subsidiaries, that do have business operations. The subsidiaries have their management, while the holding company oversees those managers. 

The holding company can obtain financing for the subsidiaries and receive income from them. The holding company, whether a corporation or an LLC, offers an added layer of financial protection, as the obligations of a subsidiary do not affect the holding company or other subsidiaries.

Taxation of the Member Corporation

Again, LLCs have pass-through taxation, which means that the LLC-member corporation’s share of profits must be taxed as corporate income and subject to corporate taxes. In addition, corporation shareholders are also taxed on dividends they receive from the corporation, which is sometimes called double taxation. 

Holding companies are often LLCs instead of corporations to avoid double taxation.

When a Corporation Cannot Own an LLC

There are two situations in which a corporation cannot be an LLC member. First, if the corporation is a bank or insurance company, it cannot be a member because banks and insurance companies cannot be LLCs. 

Also, a professional limited liability company (PLLC) cannot be owned by a corporation because PLLC members must be state-licensed professionals, such as doctors or attorneys. 

Can an LLC Own an S-Corp?

The IRS has specific rules regarding who can and cannot own an S-Corp. S-Corp owners:

• May be individuals, estates, or certain kinds of trusts
• They may not be taxed as partnerships or corporations
• May not be a non-resident alien shareholder

LLCs with more than one member is taxed by default as partnerships unless they have chosen to be taxed as an S-Corp or a C-Corp. Thus, per IRS rules, an LLC with more than one member cannot own an S-Corp due to its partnership or corporation status.

On the other hand, an LLC with one member is taxed as a sole proprietorship. IRS rules do not prohibit sole proprietorships from owning an S-Corp. Thus, an LLC with only one member can own an S-Corp.

Why Does the IRS Restrict S-Corp Ownership?

An S-Corp has pass-through taxation, so if an LLC owns a share of the S-Corp, S-Corp profits will pass through to the LLC. However, if the LLC has an owner who is not required to file U.S. taxes, that income would pass through the S-Corp, then through the LLC and to the owner, and would not be subject to taxation. 

Without this rule, someone could use an S-Corp to avoid taxation altogether.

How Can I Purchase a Company with S-Corp Status?

If your LLC cannot own an S-Corp but is still interested in buying an S-Corp, you’ll have to make the purchase yourself. Like your LLC, the new company would still benefit from personal liability protection and pass-through taxation. You would own two separate business entities.