Many people who start businesses start producing and selling goods or services before considering what business structure might work best. By default, they are opting into a form of a business structure known as a sole proprietorship. These businesses are typically run by one individual and are unincorporated, and for legal and financial purposes, no distinction exists between the business owner and the business itself.
However, a significant drawback with a sole proprietorship is that because of this lack of legal and financial distinction, the owner is legally and financially liable if something goes wrong. If, for example, someone gets sick after eating in your restaurant and sues you, if they win, not only might your restaurant be at risk, but you might also be required to use your personal savings to settle the judgment.
If you’ve begun to consider what business structure might shield your personal assets, you may have come across the terms “limited liability corporation” (or “LLC”) and “S corporation.” At first glance, both of these may appear like business structures that can help you shield your personal assets from creditors. But a limited liability corporation — or an LLC, is actually a business structure, while an S-corporation is an IRS tax designation that LLCs and other business types can elect to use. It’s essential to know the difference between these two concepts and how they may benefit you.
Limited Liability Corporation
A limited liability corporation is a business structure that business owners can use to keep their business and personal assets separate. An LLC can count one or more individuals as owners (known as members), none of whom would be personally financially or legally liable if the business itself is sued or declares bankruptcy.
For tax purposes, the IRS considers an LLC in a similar light to a sole proprietorship. Members must pay payroll taxes, including self-employment taxes, Medicare, and Social Security taxes. They also must pay taxes on LLC income. However, an LLC’s members can elect to be taxed as a corporation. This is where the S-corporation designation comes into play.
If the LLC members elect to be taxed as an S-corporation, the members are considered shareholders and employees of the business. These shareholders receive an annual salary for which the corporation pays the necessary payroll taxes. The S corporation is also eligible to deduct these taxes as a business expense. Profits above these payroll expenses can be paid out to shareholders as dividends, which are taxed at a rate lower than the salary income shareholders receive.
By electing for S-corporation status, a business owner can avoid the double taxation that comes with C-corporation status, where the corporation pays corporate taxes, and the business owner pays taxes on the distributions they receive from the profits. As their business grows, a business owner can also avoid the increasing self-employment tax liability that will accrue to them if they are taxed as an LLC.
Choosing Between an LLC or an S Corporation
A single person LLC may be better off being taxed as an LLC as the business owner would be forced to take a “reasonable salary” as per IRS guidelines. That may not be feasible for a fledgling entrepreneur with inconsistent revenue. But as the business grows and the owner takes on outside investments, elected for S-corporation status may make more sense.
Electing for S-corporation status does have additional implications. An S-corporation can have only 100 shareholders, all of whom must be U.S. citizens. The S-corporation must also be located in the U.S. An LLC can have an unlimited number of members, including non-U.S. citizens. LLCs can also establish subsidiaries, though S-corporations are prohibited from doing so. However, LLCs cannot issue stock, while S-corporations can do so.
Given these differences, choosing between LLC taxation and S-corporation taxation depends on the business’s size and strategic direction. But these options can help small business owners across industries minimize their financial and tax liabilities, leaving them with more cash to grow their business.