When you start a small business, you’ll have many decisions to make. The process involves everything from choosing a business model and designing your marketing materials to hiring employees and setting prices. But in the early stages, you’ll need to make some key decisions about your company’s structure — decisions that impact how you do business and what financial responsibilities you’ll encounter.
Many small businesses start as LLCs, and others start as S corps. Before you make this type of decision about your business, it’s important to understand what kinds of advantages and responsibilities are associated with each business structure. Take a look at these basics to get started.
What Are LLCs?
LLC is an acronym for limited liability company. This business structure needs to be registered with the local authority in at least one of the 50 U.S. states. In most states, the proper authority to register an LLC is the Secretary of State, Department of Revenue or a similar agency that handles business activities. Registering an LLC legally establishes the business as an entity of its own that’s separate from the individual owners.
For example, if a judge rules in a court case that an LLC should pay a plaintiff $1 million in damages, the business, not the business owner, is responsible for paying that money. The business may need to sell some equipment to come up with the money, but the business owners wouldn’t be required to sell their personal homes.
An LLC can have one owner or many owners. In an LLC, all business owners are called members, even if some ownership interest is held by corporations, partnerships or other LLCs. There’s neither a certain size nor income level that requires a business to become an LLC, nor is there an upper limit to the size of a business that’s allowed to be an LLC. Generally, businesses that have shareholders and offer publicly traded stocks need to register as corporations, and some states don’t allow financial institutions to register as LLCs. An LLC only needs to file corporate taxes if it’s a corporation or partnership. Otherwise, the owner of a single-member LLC files business profits on their individual tax return.
What Are S Corps?
S corporations, commonly called S corps, are businesses of any legal structure that chose the S corp designation for tax purposes. To become an S corp, a business must register with the IRS by filing Form 2553.
Rather than owners called members, the owners of an S corp are called shareholders. S corps are limited in size to 100 shareholders. Unlike LLCs, partnerships and people who don’t have residency in the United States cannot be among the 100 or fewer shareholders. Similar to LLCs, most financial institutions are forbidden from declaring S corp status.
Each of the shareholders is required by law to receive an annual salary. At tax time, that salary counts as personal income for each individual. The owners may also receive a percentage of the profits as shares or passive income separate from their annual salary.
An S corp is required to file corporate taxes, and the individual shareholders must file any money, salary or shares they earn from the S corp on their tax return. The key benefit of an S corp is that shares are taxed at a lower rate than income. Any shares distributed to the shareholders won’t count as income for the S corp on corporate taxes. These two facts allow the business and the shareholders collectively to avoid paying taxes twice on the same income.
How Are LLCs and S Corps Different?
In an LLC, the business owner’s income and the business’ profits can be the same money. Some LLC owners may opt to pay themselves a set amount at a specific frequency. Others draw any amount on the company’s profits anytime they want. Both are entirely legal ways for a business owner to receive compensation.
In an S corp, the business owner has a set annual salary. The corporation is its own financial entity at tax time, and an S corp must file corporate taxes. Because business owners can also claim the profits of an LLC as individual earnings, LLCs aren’t always required to file corporate taxes. If the owner of an LLC doesn’t claim all of the profits for the year on their individual taxes, the business must file.
Can a Business Be Both an LLC and an S Corp?
A business can be both an LLC and an S corp because an LLC refers to the business’s legal structure, and an S corp refers to the business’ tax structure. Many businesses that are legal LLCs file taxes as S corporations.
For example, Jill and Marcus may be equal partners in a real estate business. They register the business as an LLC with their local secretary of state but apply for S corp status with the IRS. At tax time, any business income that Jill or Marcus earn respectively counts as personal income, just as it would if either of them worked for any employer. As an S corp, the business also has an obligation to file corporate taxes. The business will likely file a tax return on a quarterly basis based on the profits it earns.
The IRS status of being an S corp doesn’t have any bearing on the legal implications of being an LLC. If the business ever runs into legal issues, the hypothetical plaintiff in a court case would sue the LLC, not its individual members (Jill and Marcus) nor the S corp (the organization’s tax status).
The similarity can be compared to a married person who files taxes separately from their spouse. They’re legally a married person, but their tax status is individual. When it comes to taxes, they, not their spouse, are responsible for their own bills. However, their tax status has no bearing on their marital status — they’re not legally single. They have the same legal ownership rights to marital property as any other married person who files taxes jointly.
The decision of whether to be an LLC or an S corp can have legal and financial implications. It’s wise to consult an attorney or financial adviser before making this choice.
