When you’re beginning the process of starting a company, you are bombarded with a multitude of choices and it can be exhausting and confusing. But after a while and once you’ve settled in and are starting to make a profit, you look for ways to best optimize your increasing income. Let’s discuss the main differences between an LLC and S Corp and what they mean for your business and your income.

What is an LLC?

A Limited Liability Company, or LLC, is a type of entity that is especially designed to give business owners legal protection and provide a means by which to separate the personal assets and legal affairs of a member with those of the entity. LLCs provide an excellent structure for a business entity to flourish. It provides both protection and convenience while offering business members flexible options for how they choose to be taxed. There is a default taxation method for LLCs, but there are two more options; S Corp and C Corp. Electing to be taxed as a C Corp is generally very rare and most businesses will choose the S Corp tax classification as their preferred alternative tax method. 

What is an S Corp?

An S Corp is not a business entity but is one of three tax designations that an LLC can elect for their business that allows companies to pass corporate income, losses, deductions, and credits through to their members in order to minimise the amount of taxes that need to be paid.

LLC vs S Corp

Structural differences

Legally and structurally, when comparing an S corporation vs an LLC, they differ fundamentally in that an LLC is an entity type, while an S Corp is an IRS tax designation. LLCs can only elect to be an S Corp if they meet the following criteria; members are able to receive a reasonable salary; the business has a positive ROI and meets the IRS requirements of an S Corp classification.

Tax classification

LLCs are not considered to have employees, and they are taxed as what’s called a “disregarded entity” where members are paid distributions in lieu of a salary. This distribution is then subject to employment tax and thereafter income tax as well. S Corps on the other hand, allow for members to receive a salary, and become employees. This means that they can receive both a salary and distributions and where the salary is subject to employment tax and income tax, under an S Corp structure, the LLC’s distribution is only subject to income tax not employment tax. This means that S Corps are able to save up to 17% on the distribution portion of their income by choosing to be taxed as an S Corp. it is important to know, however, that because the “reasonable salary” amount doesn’t specify exactly how much you should be earning, the IRS closely scrutinizes your chosen salary amount and should you be undervaluing your salary to minimize your taxes under false claims, your S Corp status can be taken away from your business.

Earnings difference

An LLC tax structure is simple and effective, and so unless your business is making enough money for you to be able to meet the criteria for S Corp status, it is not feasible for you to go through the complex process of rearranging your internal tax systems and you may even have to hire a tax practitioner or financial manager to manage the additional paperwork and administration involved in this process.

Both an LLC and an S Corp, although not technically the same thing, both offer different levels of tax benefits. The main benefit of S Corp is that it allows you to limit your employment taxes and therefore save money, but only if you have sufficient profits to justify the cost and effort involved in electing to be taxed this way, otherwise you should just keep it simple and stick to the default LLC tax structure.