Here at CorpNet, we hear from entrepreneurs every day who are trying to decide the best way to start a business or incorporate an existing business. We offer free business consultations to help people learn the ins and outs of choosing a business structure, and one of the most frequently-asked questions we get is “How can I decide between an LLC and S-Corporation?”
Most small business owners want to limit their personal liability and protect their personal assets from those of the business. Any business structure, whether it’s an LLC, S Corporation or C Corporation, can achieve this goal of personal asset protection.
The biggest differences between forming an LLC and incorporating as an S-Corporation arise when you start to look at the more complex issues of taxation, corporate structure and regulatory compliance.
If you’re a new entrepreneur or longtime small business owner who’s trying to figure out how to choose between an LLC and an S-Corporation, here are a few considerations to keep in mind:
- S-Corporations require extra paperwork: If you choose to form an LLC, your day-to-day experience of running your business is not likely to change. If you’re a sole proprietor who forms an LLC, you still can keep doing business the same way as before, you keep paying taxes the same way as before, and in general, you get the protections of incorporating without a lot of extra hassles and red tape. This is not the case for an S-Corporation. If you form an S-Corporation, you need to assign a Board of Directors, hold annual shareholders meetings, file multiple business filings throughout the year, set up formal payroll processes, and deal with various other paperwork, accounting and regulatory hurdles that you don’t need to worry about with an LLC or sole proprietorship. Many sole proprietors should think hard about setting up an S-Corporation: are you really ready for the extra complexities and costs that go with incorporating as an S-Corporation? Depending on the nature of your business and your goals, you might be better off with an LLC.
- S-Corporations can be tricky for sole proprietors: Many sole proprietors want to get the tax savings of an S-Corporation to avoid paying that dreaded extra share of self-employment taxes. (If you form an S-Corporation, the company does not pay any taxes and the earnings can be passed through to the individual owners/shareholders – and those earnings are then taxed as “employee income,” without incurring the extra 7.5% of self-employment taxes.) However, there can be a few hurdles for solo entrepreneurs who want to incorporate as an S-Corporation. As a sole owner of an S-Corporation, you need to pay yourself a salary and also assign a “distribution” of the company earnings. The distribution amount is free from self-employment tax. However, you need to be careful about how high to set your salary – if you pay yourself too low of a salary (hoping to minimize your self-employment taxes), you might get audited by the IRS and have to pay tax penalties. But if you set your salary too high, you run the risk of overpaying your self-employment taxes. This situation is complicated and we encourage you to talk with a professional tax adviser prior to deciding to incorporate as an S-Corporation.
- S-Corporations require owners to be U.S. citizens or permanent residents: The business world is more international than ever before – so if you’re starting a business with partners from other countries (or located in other countries), an S-Corporation is probably not the best choice. Under U.S. tax laws, owners of an S-Corporation must be U.S. citizens or permanent residents – but this restriction does not apply to LLCs or other business structures. This is a small but important consideration if you or your business partners are not U.S. citizens or permanent residents.
NOTE: CorpNet does not give tax advice and this article does not claim to do so. Please consult with a professional tax adviser before making any final decisions about whether to incorporate as an S-Corporation (or other corporate entity) and how to handle your corporate and personal income tax responsibilities.