Should Your S Corp be an LLC or a Corporation?
An S corporation (S corp) can offer your business tax advantages. As an IRS tax classification, an S corp can be elected by formal business structures, such as LLCs or corporations, but should your S corp be an LLC or a corporation? The answer to this question depends on your company goals, business needs, and finances.
That said, an LLC is easier to set up than a corporation. Once you’ve set up the best business structure for your business, you’ll have to elect S corp status to be taxed as an S corporation.
Pro Tip: Get a free consultation with a tax professional to determine if an S corp is right for you.
What Is an S Corporation Simplified?
When it comes to starting an S corporation, many business owners wonder, should your S corp be an LLC or a corporation? Before selecting what type of business structure is best for your S corporation (S corp), you should be clear on what is an S corporation.
An S corp is a tax classification from the Internal Revenue Service (IRS) code that a limited liability company (LLC) or a corporation can elect for tax purposes. There are specific S corp requirements the IRS lists before you can apply. Some of these include that a business is a domestic entity with a maximum of 100 shareholders who are U.S. citizens or permanent resident aliens, among other requirements.
In an S corp, the owners become employees who must pay themselves a reasonable salary. This allows them to save money on self-employment taxes (social security and medicare) on the remaining earnings known as distributions. Since S corporations have pass-through taxation, all profits, credits, losses, and deductions go straight to the shareholder to pay on their individual tax return.
S Corp Requirements
The IRS requires that businesses that elect the S corp status:
- Have 100 shareholders or less
- Are domestic LLCs or corporations
- Issue only one class of stock
- Shareholders are U.S. citizens or permanent resident aliens
- Are owned by private individuals
LLC
An LLC offers limited liability protection, which means that your personal assets are protected (house, cars, etc.) in case of a lawsuit or from creditors collecting outstanding debts. LLCs also have pass-through taxation, where profits and losses go directly to the owners, allowing shareholders to pay taxes on their individual tax returns instead of the business itself being taxed. However, some states like California and New York may impose a tax on S corps at the corporate level.
Starting an LLC with the intent to be taxed as an S corp is a common small business practice. To do so, you'll first have to start an LLC by filing the Articles of Organization and then IRS Form 2553, which will allow your business to formally be taxed as an S corporation.
What Are the Costs to Start an LLC?
There are state filing fees involved when it comes to starting an LLC. These fees depend on the state where you form your business and can range from $40 to over $500. To find out more about costs on starting an LLC, check out our LLC costs guide.
You can choose to start your own LLC and elect S corp status, or decide to have a professional service like Collective do it for you for an additional fee. Having an S corp service start your business is a good idea since a professional business formation company can provide real value through experience and by preventing costly errors that can delay your business formation.
Why an LLC Is the Best Structure for the S Corp Tax Status
As entrepreneurs, we believe that starting an LLC is the best way to start an S corporation because any advantages of forming a corporation are negated by S corp restrictions. LLCs are also generally easier to maintain than corporations.
New York is the only state where this may not be true due to the state’s LLC publication requirements.
S corps are also subject to double taxation in New York City since they are not recognized and must pay the city’s 8.85% business tax, in addition to federal and state taxes. This is not the case in most states. However, as a salaried employee and depending on your business's income, you can still qualify for tax savings on distributions in New York City. The distributions only pay income tax and not self-employment taxes.
When Should I Convert My LLC to an S Corp?
You should convert your LLC into an S corp when your business makes enough profits to pay owner salaries and has at least $20,000 in annual distributions after paying business expenses. You should also be able to cover monthly accounting, such as payroll and bookkeeping costs, without just breaking even to really benefit.
We recommend that you start an LLC instead of a C corporation when starting or converting your business into an S corp. An LLC requires less paperwork and time than starting a C corporation (the default corporation tax status). Corporations have a standard, strict operating structure and require detailed recordkeeping for government reporting. They also require a board of directors, meticulous minute meetings, and have strict tax deadlines throughout the year that will add up to additional business costs.
In general, an LLC is less expensive as well as easier to form and maintain than a corporation.
Recommended: Hire a service provider like Collective for all your S corporation needs.
S Corp Tax Advantages, Distributions, and Reasonable Salary
S corp tax advantages come from having a reasonable salary that saves you money on distributions. Distributions are net earnings (profits after salary and business expenses). The IRS requires that you pay yourself a reasonable salary — what any other employer would pay someone in your position based on the market — to safeguard against business owners lowering their wages to save on self-employment taxes.
As a salaried owner-employee, the salary portion in an S corp is subject to self-employment taxes and income tax, while the distributions only pay income tax. The tax savings on the self-employment portion of the distributions can be significant compared to a default LLC, where all net profits are subject to self-employment taxes and income tax, or a default corporation’s double taxation.
Corporation
A default corporation is known as a C corporation (C corp). Like the S corp status, a C corp is also a tax classification. However, a C corp is known for its double taxation. Converting a C corp to its S corp tax status counterpart allows a business to bypass taxation at the corporate level in most states. Starting a corporation and converting it to an S corp can be beneficial under the right business circumstances.
When Should I Start a C Corp?
You may want to start a C corporation if, for example, you want to secure outside investors, offer different types of stock options, grow your business without restrictions, or even take your company public. C corps can offer different tax benefits as well. Some of the tax advantages for shareholders include taxpayer exclusions on gains from “Qualified Small Business Stock” sales (under IRS Section 1202) if the stock is held for longer than 5 years, deferment on gains upon reinvesting in these types of stocks within a specific timeframe, in addition to other tax allowances for businesses.
Make sure to consult your accountant to understand if and when you should start an LLC, corporation, or convert either of these formal business structures into an S corp based on your company finances and business needs.
When Should I Convert a C Corporation to an S Corp?
If you start a C corporation and want to convert it to an S corp for its tax advantages, you may want to start looking into your business earnings and if you qualify for S corp requirements as a compass to guide you.
Generally, corporations cost more than LLCs and require more paperwork. You’ll have monthly payroll and bookkeeping expenses that should justify the election of either an S corp or a C corp. Some states don’t recognize S corps (e.g., New York), others require filing additional forms for the S corp tax status (e.g., New York), while a handful may have a franchise or other state tax (e.g., California and New York).
If you’re trying to grow your business, you will probably benefit from a C corp as long as you’re not breaking even from monthly accounting expenses (payroll, bookkeeping, other expenses), whereas an LLC may make the most sense without S corp or C corp election. The goal is to choose the best business type and tax structure while securing a healthy profit.
Corporations require a lot from their owners/shareholders (e.g. minute meetings, board of directors, etc.) and are costly. Many business owners want to avoid a C corp’s double taxation and find converting to an S corp more appealing for this reason and for the self-employment tax savings on the distributions.
Recommended: We recommend starting an LLC and converting it to an S corp over starting a C corporation. LLCs have fewer costs and require less paperwork beyond filing the Articles of Organization and Form 2553 (with the exception of additional forms in a few states).
Looking to start an S corp or convert your existing LLC and start saving on taxes? Find your all-in-one S Corp business solution with Collective.
Steps to Take After Forming an S Corp
Once you formalize your S corp, consider adding a business phone line to protect your personal information with phone.com.
If you need to build your S corp credit, read our guide on how to build business credit and get a business credit card through Divvy.
FAQs
An S corporation (S corp) is a tax designation for which an LLC or a corporation can apply for through the IRS by completing and filing Form 2553 Election by a Small Business Corporation.
C corporations (C corps) and S corporations (S corps) are two different types of tax statuses. S corps and C corps are often misunderstood to be business structures.
S Corporation
In an S corp, the business itself is not taxed.
An S corp allows business owners to become employees of the business and can reduce the tax burden under the right circumstances. LLCs and corporations can elect an S corp status. S corps have pass-through taxation, meaning that all profits are passed down to the members as in a default LLC.
The members (owners) of LLCs are not salaried employees like in an S corp, so profits pay both income tax and self-employment taxes on the shareholder's personal income tax. In an S corp, the owners or members save on employment taxes due to only the salary being subject to self-employment taxes; the distributions only pay income tax.
C Corporation
In a C corp, the business is taxed at a flat rate (currently 21%). A business taxed as a C corp faces double taxation because after the business is taxed, the shareholders are then taxed on their distributions on their personal income tax. For some corporations, the benefits can outweigh the disadvantages of double taxation.
Learn more in our S corp vs. C corp guide.
No. An S corp is a tax status that an LLC or a corporation can elect to report a business's federal and state income taxes.
You can form an S corp by starting an LLC or a C corp and filing Form 2553 with the Internal Revenue Service (IRS) to elect S corp status.
S corps must meet four requirements:
- They can have no more than 100 shareholders.
- All shareholders must be US citizens who are private individuals (not other business entities).
- Shareholders cannot be nonresident aliens.
- The business may only issue one class of stock — this means all members must have the same distribution amount.
Owners of S corps are considered employees of their company, and they can save thousands of dollars on self-employment taxes as a result.
No. The default taxes for an LLC and taxes for an S corp are not the same.
With an S corp, owners pay personal income tax and self-employment tax on a predetermined salary. They may then withdraw any remaining profits from the business as a “distribution,” which isn’t subject to self-employment tax.
With an LLC, all company profits pass through to the owners’ personal tax returns, and then the owners must pay personal income tax and self-employment tax on the entire amount.
Both LLCs and S corps benefit from a provision in the Tax Cuts and Jobs Act of 2017 that allows qualifying owners of pass-through entities to deduct 20% of qualified business income (QBI) from their tax return. However, for S corps, the deduction doesn’t apply to profits paid out as wages.
Unlike a default LLC business structure, in which owners must pay self-employment tax on all of the company’s profits, owners of S corps are considered employees of the business and only have to pay self-employment tax on a salary they receive. Any other money they take from the company’s profits in the form of disbursements isn’t subject to self-employment tax.
S corp owners are required to earn a “reasonable” salary, which basically means a fair market rate based on the individual’s qualifications as well as their duties and responsibilities at the company. The purpose of this requirement is to prevent S corp owners from paying themselves an artificially low salary in order to pay less self-employment tax.
A distribution is a dividend that a shareholder/owner can take from the business profits that remain after a company pays all of its employee salaries. Shareholders must pay personal income tax on distributions, but distributions aren’t subject to self-employment tax.
Pass-through taxation is a system of taxation that generally applies to sole proprietorships, partnerships, LLCs, and S corps. In this system, the profits or losses of the business are not taxed at the business level. Instead, they pass through to the owners’ personal tax returns and are taxed at each owner’s personal income tax rate.
There’s no corporate tax rate for S corps. Instead, owners of S corps pay personal income tax on the company’s net profits. This rate depends on each owner’s personal income tax bracket.
LLCs and corporations that operate under a “doing business as” (DBA) name can choose the S corp election.
How LLC owners pay themselves depends on how the LLC is taxed, the number of members, and any agreements regarding profit sharing and sweat equity.
In a single-member LLC (SMLLC) or multi-member LLC (MMLLC), you can pay yourself:
- a distribution that passes through to your individual tax return, or
- a reasonable salary and distribution as an S corp
Read our guide to learn more about how to pay yourself from an LLC.
Would you like to speak to a professional service that can handle your bookkeeping, tax filing, and regulatory requirements so you can focus on running your company? Collective can do all that and more.