S Corp or LLC – Which is Right for My Business?
At some point, each new business owner must determine which type of entity to form. Perhaps a C Corporation? An S Corporation? Maybe a limited liability company? Thankfully, this decision need not be as complicated as it might seem. While C Corporations—corporations taxed under Subchapter C of the Internal Revenue Code—are popular, particularly among larger businesses, C Corps are subject to two layers of taxation: once at the corporate level and once at the shareholder level. On the other hand, S Corporations (“S Corps”)—corporations taxed under Subchapter S of the Internal Revenue Code—and limited liability companies (“LLCs”) are generally subject to only one layer of taxation, a difference which could mean millions of dollars in tax savings over the course of a business’s life. Understanding the differences between an S Corp and an LLC is critical to ensuring your business is set up for success moving forward.
For state-law purposes, the process of forming an S Corp is identical to that of forming a C Corp. In Indiana, that means choosing an entity name, filing articles of incorporation, and paying a filing fee. In order to become an S Corp, the corporation must then file what is known as an “S Election”—Form 2553—with the Internal Revenue Service (“IRS”). From there, as long as the corporation meets certain S Corp eligibility requirements set forth in the Internal Revenue Code, the corporation will be taxed as an S Corp. By contrast, an LLC is not formed like a corporation. In Indiana, forming an LLC requires choosing an entity name, filing articles of organization, and paying a filing fee. No additional elections are necessary for IRS purposes.
Difference Between LLC and S Corp
Perhaps the most fundamental difference between an S Corp and an LLC is the way the entity is treated for tax purposes. While LLCs are often treated as pass-through entities, meaning the income of the LLC flows through to its members, S Corps are accounting entities, meaning the S Corp itself calculates income and deductions at the corporate level before income is allocated to individual shareholders.
Another primary difference between S Corps and LLCs relates to who is permitted to own the entity. While most states allow individuals, corporations, partnerships, and other entities to be “members,” or owners, of an LLC, only U.S. citizens and permanent residents may be shareholders of an S Corp. Additionally, for an S Corp, only limited types of entities may be shareholders and the total number of shareholders must not be greater than one hundred.
In terms of day-to-day operations, perhaps no difference between the two entity types is more significant than the lack of corporate formalities associated with LLCs. In Indiana, for instance, both S Corps and C Corps are required to hold annual meetings of shareholders and directors. By contrast, there is no such requirement that members or managers of an LLC hold such meetings. In addition, while Indiana S Corps and C Corps must have at least one corporate “officer,” LLCs need not have officers at all.
To this point, it may sound as if the LLC is inherently a superior entity to the S Corp. While that may be true in some cases, S Corps offer significant tax benefits to businesses earning excess profits. S Corps are required to pay their employees “reasonable” salaries (meaning salaries paid should be comparable to other businesses in the same industry), but all excess profits can be distributed to shareholders as dividends, which are taxed at a lower rate than ordinary income.
The differences between S Corps and LLCs can be complex, and this article only scratches the surface for some of the main differences between the entities. Making sure your business is properly organized is a key step toward future success. For questions regarding your business, please contact a business attorney at Barrett McNagny.