LLC vs. S-Corp: Understanding the Differences

Both structures have unique advantages and potential drawbacks, which we'll explore in detail in this guide.

What Is an LLC?

An LLC is a widely used business structure, especially for startups, because it provides several advantages. It offers personal liability protection, meaning the owners' personal assets are generally safe if the business is sued or cannot pay its debts. An LLC is also a pass-through entity for tax purposes, so the company itself does not pay taxes.

Instead, profits and losses flow through to the members, who report them on their personal tax returns. LLCs also provide significant management flexibility, with very few formal requirements for how the business should be run.

What Is a Corporation?

A corporation is more complex than an LLC and comes with stricter legal requirements. Corporations are owned by shareholders who hold shares of stock and benefit from the company's profits, but they are not personally responsible for the company's debts. Management of a corporation is formalized through a board of directors, which oversees strategic decisions and business planning.

Corporations must also adhere to regulations like holding annual meetings, appointing officers, and maintaining detailed corporate records. Unlike LLCs, corporations pay taxes on their profits, and shareholders must also pay taxes on dividends they receive, which results in double taxation.

LLC vs. S-Corp: Key Differences

Ownership

• LLC: Owners are called members. The operating agreement defines each member's ownership percentage, profit share, responsibilities, and procedures for transferring ownership.
• S-Corp: Owners are shareholders, and ownership is based on the number of shares held. Shareholders receive dividends proportional to their shares. Shares are easily transferrable, which makes corporations attractive to investors.

Administration

LLCs are generally easier and less expensive to establish than corporations. They are not required to have a board of directors or hold formal annual meetings, though many states require annual reports. Corporations are more complex and require structured governance and recordkeeping.

Control

LLC members have full control and can organize management as they wish. In contrast, corporate managers answer to the board of directors, which holds ultimate decision-making authority.

Limited Personal Liability

Both LLCs and S-Corps offer liability protection. Owners are separate from the business, but liability can arise if they personally guarantee loans, commit fraud, or violate operating agreements or corporate bylaws.

Taxes

LLC:

• Single-member LLCs are taxed as sole proprietorships; multi-member LLCs are taxed as partnerships.
• Members pay self-employment taxes unless electing S-Corp or C-Corp taxation.
• LLCs can elect corporate taxation by filing IRS Form 8832 (C-Corp) or Form 2553 (S-Corp).

S-Corp:

• Pass-through taxation avoids corporate-level taxes.
• Shareholders may be treated as employees and paid salaries, reducing self-employment taxes.
• Requires additional payroll and accounting work, which is only cost-effective if tax savings exceed expenses.

Profit Sharing

• LLC: Profit allocation is flexible and can be customized in the operating agreement. One member may receive more than their ownership share based on involvement or responsibilities.
• S-Corp: Profits are distributed according to share ownership, limiting flexibility compared to LLCs.

Choosing the Right Entity

LLCs are often ideal for small businesses or solo owners seeking simplicity and protection. S-Corps may be more appropriate for companies planning to raise investor funds or wanting to minimize self-employment taxes while meeting the more formal corporate requirements.

Can a Corporation Own an LLC?

Corporations can own LLCs, often acting as a holding company that owns multiple subsidiaries. A holding company:

• Maintains control over subsidiaries without direct involvement in daily operations.
• Can provide financing to subsidiaries and receive income from them.
• Offers financial protection by separating liabilities among companies.

A corporation may also acquire or purchase controlling interests in an LLC, effectively converting it into a corporate-owned entity.

Taxation for a Member Corporation

LLCs are pass-through entities. If a corporation owns an LLC, the LLC's income is treated as corporate income and taxed accordingly. Shareholders are also taxed on dividends. Many holding companies prefer LLC status to avoid double taxation.

When Corporations Cannot Own an LLC

Corporations cannot own LLCs in certain cases:

• Banks or insurance companies are prohibited from being LLC members.
• Professional LLCs (PLLCs) must be owned by state-licensed professionals, such as doctors or lawyers, and cannot have corporate members.

Changing an LLC to S-Corp Status

To elect S-Corp taxation:

• File Form 2553 with the IRS.
• Filing must occur no later than 2 months and 15 days after the tax year begins or any time before the year in which the election will take effect.

Changes After Electing S-Corp Status

• Ownership limits: Maximum of 100 shareholders; all must be U.S. citizens or residents.
• Management requirements: Must appoint a board, hold annual meetings, keep minutes, and designate corporate officers such as CEO and CFO.

Can an LLC Own an S-Corp?

• Single-member LLCs can own S-Corps.
• Multi-member LLCs cannot, as they are taxed as partnerships by default.

The IRS restricts S-Corp ownership to ensure pass-through taxation is applied correctly and to prevent tax avoidance.

Purchasing an S-Corp

If an LLC cannot own an S-Corp but wants to acquire one, the purchase must be made personally. Both entities retain liability protection and pass-through taxation.