What is the Difference Between an LLC and S Corp?

An S corp is an IRS tax classification that can be elected by either an LLC or a corporation and an LLC is a business structure type.

An LLC can file taxes under the "default LLC" classification, or it can elect the S corp classification.

Most small businesses file taxes under the default LLC tax classification. This is because small businesses don't usually don't have profit left over after paying expenses to make the S corp tax status beneficial.

Under an S corp, business owner(s) can save about 17 percent on the distribution portion of their income if the following statements are true:

  • The business can pay the owner(s) a "reasonable salary".
  • There are substantial distributions year over year.
  • There is a positive return on investment for payroll service costs.
  • The business meets S Corp requirements.

diagram showing the differences between s corporations and L L Cs

When to Use the S Corp Tax Classification

It only makes sense to file taxes as an S corp if there is enough net profit to pay owners a reasonable salary and at least $10,000 in annual distributions.

The S corp tax classification allows business owners to be taxed as employees of an LLC. Under an S corp, the business owner pays FICA (Medicare and Social Security Tax) and income tax on their salary. Distributions are only subject to income tax.

S Corp Tax Benefit: Instead of paying self-employment tax and income tax on all distributions from the business, an S corp owner pays only FICA and income taxes on their salary and only income taxes on distributions. This could lead to major tax savings in the right circumstances.

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 profit and pay distributions.
  • The financial tax advantage must offset the cost of maintaining the S corp.
  • The business must meet IRS S corp requirements.

diagram showing the requirements of an s corp

Reasonable Salary

Under an S corp election, LLC owners become employees. The IRS requires owner-employees to be paid a reasonable salary. A reasonable salary is any salary that you would pay someone to do the same job.

LLCs taxed as S corps are subject to increased scrutiny by the IRS. If the owner is not paid a reasonable salary, this may lead to the IRS denying S corp status and may lead to fines and back taxes.

To determine a reasonable salary for your position, you can compare similar salaries on websites like Glassdoor or the US Bureau of Labor Statistics.

Profit and Distribution

The S corp election allows a business owner to disburse an LLC's profit to owner-employees in the form of salary and distributions. The IRS then applies FICA and income taxes to only the salary. Distributions are subject to only income tax.

If the LLC doesn't earn enough profit to cover a reasonable salary and distribution, it won't make financial sense to elect the S corp tax classification. And, if the LLC owner(s) would like to forfeit salary for any reason, they could be subject to fines by the IRS. 

Positive Return on Investment

It costs money to elect and maintain an S corp. Filing fees with the IRS are minimal but the additional bookkeeping and payroll costs are not. For LLCs that already have employees and payroll costs, this factor won't hold as much weight. 

Business owners should weigh the cost of maintaining these services against the fiscal tax advantage of electing the S corp classification. Generally speaking, a reasonable salary plus $10,000 in annual distributions is often enough to make electing the S corp financially viable.

IRS S Corp Requirements

The IRS requires that businesses that elect the S corp status have 100 shareholders or less and they are only allowed to issue one class of stock.

The owners of the business must be US citizens or permanent resident aliens. Owners must also be private individuals and not business entities such as LLCs, corporations, or trusts.

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When to Use the Default LLC Classification

Many LLCs will benefit most from the default LLC tax classification. LLC owners often put any profit back into their small businesses each year to promote growth. And without substantial distributions, there's no basis for electing the S corp tax status.

Default LLC Tax Benefit: Business owners can choose to reinvest as much of the business's profit as they see fit in any given tax year.

The default LLC tax structure is best suited for businesses with these characteristics:

  • Their owners reinvest profit back into the business to promote growth
  • The cost of bookkeeping and payroll services would outweigh the tax benefit of an S corp

diagram showing the requirements of a default L L C

Reinvesting LLC Profit and Pass-Through Taxation

If you expect to reinvest most of the profit back into your small business, default LLC status is the right choice.

Small businesses usually have a low amount of net profit in any given year. This is because small businesses usually spend most of their income on expenses like marketing, software, and office equipment to help the business grow. Some owners also want the choice to not pay themselves and that's not possible with an S corp classification.

Pass-Through Taxation

When LLC owners choose to reinvest profit, very little net income (profit minus expenses) from the business will pass-through to the LLC member(s) individual tax returns. 

You can visit our LLC Pass-Through Taxation guide to learn more about how default LLCs are taxed.

Return on Investment

For some LLCs, the cost of hiring a payroll service and bookkeeper would outweigh the financial tax advantages of electing S corp tax classification. These LLCs would be best to operate as a default LLC.

Should Your LLC Elect S Corp Classification?

Whether or not an LLC should elect S corp status depends on how much profit the business is going to earn and carry-over from tax year to tax year.

Generally, if you know your business is going to have an annual distribution that is greater than $10,000 after paying yourself a reasonable salary, then your business has enough profit to justify becoming an S corp.

If you are unsure how much profit the LLC will make or if you want to reinvest the profits back into your LLC, it’s best to remain in the default LLC classification with the IRS. You can apply for an S corp status when it better suits your business. 

To elect to become an S corp, file Form 2553 with the IRS. Visit our instructions for form 2553 page for help with completing the form.

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