Both the LLC and the S corporation offer personal limited liability protection to the owners of each entity.
Both the LLC and the S corporation offer a single layer of pass through taxation so profits of a business run through either of such entities are not subject to the double taxation of C corporations.
The difference comes in when it comes to qualification and to operations.
QUALIFICATION FOR SINGLE LAYER OF TAX
An LLC is formed under state LLC law requirements and once a limited liability company is formed, it automatically qualifies for a single layer of taxation under the Internal Revenue Code. There are no conditions, no filings and no requirements to obtain this preferred taxation structure.
With an S corporation, the owners have to first form a regular corporation under state corporation laws. Once formed, the owners of the corporation and the corporation itself must meet a laundry list of conditions and requirements.
I will not list them here but examples include limitations as to who can be an owner, where owners can reside, and limitations on how the equity is structured in the S corporation.
It is important to know that the S corporation must not only meet these conditions and limitations at inception but throughout its existence so there is an additional, potentially onerous requirement to ensure that as the business grows and changes, it never fails to meet these requirements.
Even accidental noncompliance can result in large tax obligations.
After a corporation has determined it meets and will be able to continually meet the S corporation rules, the corporation must file an election form with the IRS to elect S corporation treatment.
OPERATIONS AND GOVERNANCE
An S corporation is a term defined in the tax laws to qualify a regular corporation for the single layer of pass through taxation (known as partnership taxation). From a non-tax perspective, the S corporation must meet all the formalities and requirements of a regular corporation under state law.
This generally means that it must have a Board of Directors and hold annual shareholder and director meetings. There are more governance formalities and requirements expected out of a corporation.
An LLC is not subject to such formalities and an LLC can tailor its operational and management rules and structures to however it sees fit. In summary, there are less formalities and more flexibility when it comes to using an LLC for operating a business.
SELF EMPLOYMENT INCOME
There is an advantage to being an S corporation when it comes to self employment income. If you plan on running a business that will be generating substantial profits – more than what you would be paid in salary as an executive of a company that runs your business, there is an opportunity to avoid paying self employment taxes on the amount that would be in excess of a reasonable salary to you.
While this can be a significant benefit of an S corporation under the self employment tax laws, the tax laws actually allow an LLC to elect to be taxed as an S corporation (assuming it meets the same conditions and requirements).
What does this mean? This means that when your business gets to a level of producing enough income that the self employment benefit becomes relevant, your LLC can elect S corporation status and gain the same tax benefits.
However, because your entity is an LLC, you still get the lesser formalities and more flexibility under state law to continue to run your business according to your particular needs and circumstances.
So when considering whether to form an LLC or S corp, the S corp was the old way of gaining tax benefits. The LLC is the new legal entity that both state legislatures and the IRS deem to be relevant for the typical small business owner.
It does not bog owners down with legal requirements and formalities and it allows flexibility to accommodate the most simple to the most complex of business requirements.
