1/29/2025

Understanding the Differences Between LLCs & S Corps for Tax Purposes

When starting a business, one of the first big decisions you must make is the type of legal structure it will have. In the realm of small businesses, you often find yourself torn between two popular choices: the Limited Liability Company (LLC) and the S Corporation (S Corp). Both options have their own sets of benefits & drawbacks, but they differ significantly in how they're taxed. Understanding these differences can make a hefty impact on your business’s bottom line.

What is an LLC?

An LLC, or Limited Liability Company, is a business structure in the United States that offers personal liability protection to its owners, known as members. LLCs can be owned by a single individual (single-member LLC) or multiple members (multi-member LLC). This kind of business structure allows members to enjoy the flexibility of a partnership while also providing the liability protection associated with a corporation. Learn more about LLCs here.

Taxation of an LLC

Generally, LLCs are considered pass-through entities. This means they do not pay federal income taxes at the business level. Instead, profits and losses are reported on the members' individual tax returns, which can be a beneficial aspect for small business owners. Here’s how it works:

Single-Member LLC: This type of LLC is treated as a disregarded entity for tax purposes, meaning it's taxed like a sole proprietorship, and profits are reported on Schedule C of the owner's personal tax return.
Multi-Member LLC: These LLCs are taxed as partnerships unless they elect to be treated as a corporation. The LLC files Form 1065, U.S. Return of Partnership Income, and each member receives a Schedule K-1 that reports their share of profits and losses.

Because LLCs are pass-through entities, they avoid double taxation. The income “passes through” to the owners’ personal income tax returns, allowing them to pay any applicable income taxes at their individual rates. This might save some dollars in tax payments compared to corporations.

What is an S Corporation?

On the other hand, an S Corporation (S Corp) is a special type of corporation created through an IRS tax election. Much like LLCs, S Corps provide limited liability protection for their owners, but there are some crucial differences, especially concerning taxation. Check out more about S Corps here.

Taxation of an S Corporation

S Corps also enjoy pass-through taxation, but they are subject to more stringent regulations from the IRS compared to LLCs. Here’s what you need to know:

Shareholder Limitations: S Corps can have a maximum of 100 shareholders, all of whom must be U.S. citizens or resident aliens. S Corps cannot have non-resident aliens as shareholders.
Single Class of Stock: S Corps are restricted to issuing only one class of stock, which can limit the flexibility in structuring ownership.
Salary vs. Distributions: S Corps must pay their owners (who are often also employees) a reasonable salary, with the salary subject to payroll taxes. However, any distributions (profits beyond the salary) are not subject to self-employment taxes, which can potentially lower the overall tax burden for a business owner. The distributions passed onto the shareholders’ personal returns may also benefit from lower tax rates than salaries.
Filing Requirements: S Corps are required to file IRS Form 1120-S, which reports the income, losses, deductions, and credits of the corporation. Shareholders will then get a Schedule K-1 detailing their share of income and deductions.

Key Differences in Taxation Between LLCs & S Corps

Self-Employment Taxes: LLC members typically pay self-employment taxes on the whole profit of the business, while S Corp shareholders only pay self-employment taxes on their salaries. This advantage can lead to significant tax savings for S Corp shareholders, particularly when the business is generating significant income.
Salary Requirements: S Corps must follow IRS guidelines for what constitutes a reasonable salary, often leading to higher scrutiny. Failing to meet these guidelines may result in the IRS reclassifying distributions as wages and imposing penalties. LLCs, conversely, do not have these restrictions.
Choice of Taxation: LLCs have flexible taxation options. They can choose to be taxed as a sole proprietorship, partnership, C Corp, or S Corp. This allows for strategic tax planning while S Corps are inherently structured as S Corps for tax purposes.
Complexity & Formalities: Operating as an S Corp is often more complex than functioning as an LLC. S Corps have stricter rules, regulations, and administrative burdens that require more formality, such as holding regular meetings and maintaining corporate minutes. LLCs can be simpler to manage, which may be advantageous for small businesses aiming for fewer administrative headaches.

When to Choose an LLC Over an S Corp

For many small businesses, an LLC may be the most beneficial structure for tax purposes due to its flexibility, simpler management, and broader ownership options. If you:

Prefer to keep things simple with fewer formalities,
Want maximum flexibility in profit distribution,
Don't intend to attract investors or have more than 100 members,
Want to retain complete control without meeting strict regulatory requirements, then the LLC structure might suit your needs best.

When to Choose an S Corp Over an LLC

Alternatively, if your priorities include reducing self-employment taxes and you meet the eligibility requirements, S Corps can save you money. Particularly if:

You’re planning to pay yourself and any other shareholders a reasonable salary,
You expect to generate enough profits for salary and distributions,
You want potential for attracting investors by presenting a more formal corporate structure, then forming an S Corp may align better with your long-term objectives.

A Smart Choice: Combining Strengths with Arsturn

Regardless of the entity structure you choose, making informed decisions regarding taxes can significantly impact your business. It's critical to understand your options and consult a tax professional or attorney to figure out your best game plan.

If you're ready to engage more deeply with your audience and streamline operations, consider leveraging the power of Arsturn. With Arsturn's intuitive no-code AI chatbot builder, you can create custom chatbots for your website, making it easier to answer FAQs, handle inquiries, and drive customer engagement without needing extensive coding skills. Join countless business owners transforming their outreach strategies with conversational AI solutions that suit any business need!

Final Thoughts

In the world of entrepreneurship, understanding LLCs and S Corps for tax purposes is crucial. Each option offers unique advantages & challenges that can shape how your business operates, raises capital, and plans for future growth. Take the time to analyze your situation, consult with experts, and explore which structure aligns best with YOUR aspirations!