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LLC and S Corps: which one is better?

February 17 2021

When you're trying to decide LLC v. S Corp, you should first make sure you understand the full picture of choosing your entity.

This blog is great at giving you a deep dive of state and tax law entity comparisons with LLCs and corporations for small businesses. We'll do a two-step process: Step 1: Pick your state law entity. Then Step 2: Once you have a state law entity, we'll know your choices for tax law entity and help you identify the best fit. So let's get started:

If a business has one owner, you have five choices:

  • LLC + Disregarded Entity;
  • LLC + C corporation;
  • LLC + S corporation;
  • Corporation + C corporation; and
  • Corporation + S corporation.

If those choices aren't clear to you, get the background on them first here.

Step 1: Pick your State Law Entity

(LLC or Corporation)

While your state-law entity choices for a single-owner Small Business are LLC or corporation, more businesses in this category choose LLC. Typically, LLCs have an advantage as a state law entity because:

Why LLCs are better than S Corps

LLCs are easier to form and easier to operate.

They’re easier and faster to form and require less ongoing corporate formalities that are required by corporations. With corporations, you’re supposed to hold annual shareholder meetings, elect a board of directors, have regular board meetings, elect corporate officers, and pass resolutions, among other things.

And let's be completely honest -- there's not much of a difference for most single-owner businesses between LLCs and corporations. It's funny how if you ask 10 different business attorneys what entity is better for you, I'd wager that 70% of them will say LLC. The other 30% would say corporation.

And oftentimes if you dig deep enough, the answer was either LLC or corporation simply because that's what the attorney was used to -- those are the better forms he or she had. (this isn't always true of course -- but is true enough to note). 

Corporations are more complex

So, it's nice that LLCs are simpler. If you’re a corporation, you have to file additional tax paperwork. (We’re assuming that no one in this small business category will be a C corporation, so we’ll only cover S corporation here.)

If you’re an S corporation, among other things, for taxes you have to file:

  • Form 1120S - S corporation tax return. This is for informational purposes for the IRS, not how you pay tax, since being an S corporation makes you a pass-through entity.
  • Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, Etc. S corporations use this schedule to report to each person who was a shareholder at any time during the S corporation's tax year (and to the IRS).
  • But also, even if you’re the only owner, the IRS will consider you to be an employee of your company, so you’ll have to file the employer forms (even if you’re the only “employee” and owner). You’ll also have to pay State Taxes, even if you don’t have any other employees.

One caveat—you can usually get around a lot of that by hiring a payroll service for around $50/month. But the point is—being a corporation can involve more work.

If you’re an LLC, you’re not considered an “employee” of your company and because (assuming you’re the only owner) your entity is considered “disregarded” by the IRS, typically the vast majority of tax-related work you need to do is on your own personal tax return.

LLCs often can have the same or better liability protection

Limited liability companies do have a couple of true advantages when it comes to limitation of liability.

Preserving the "Corporate Veil"
One advantage is that LLCs make it easier to preserve a company’s “corporate veil.” One of the factors courts consider when determining whether to “pierce the corporate veil” is whether the business owners observed required corporate formalities. “Piercing the corporate veil” means that a court will hold a company’s owners personally responsible for the company’s liabilities.

With corporations, this usually involves holding annual meetings of shareholders and directors, board approval of important decisions, and the like. And it’s very common for small business owners to completely neglect these formalities after they have an attorney set up their company. Such formalities are usually less involved with LLCs.

Charging Order Protection
Another liability advantage is what is known as charging order protection. Think of this (very loosely) as a corporate veil in reverse. Whereas the corporate veil protects business owners from the liabilities of their businesses, charging orders protect businesses from the liabilities of their owners.

When a business owner’s judgment creditor executes a judgment against their ownership in an LLC, the creditor’s exclusive remedy is a charging order, which is essentially a lien on the owner’s distributions from the LLC.

The creditor isn’t permitted to take the owner’s membership interest from the owner or take company assets from the LLC, but the creditor does have dibs on the business owner’s distributions from the LLC. This can permit the business owner to preserve the business to a certain extent in difficult situations.

One important caveat

But, before you make your decision, it’s worth balancing the slight advantage LLCs have versus whether they could cost you any extra fees. For many states, LLCs are the same or less in fees than corporations and are less of a hassle. But for some states, the fees are substantially higher for LLCs (California in particular) and so if you’re a hobby business, LLCs might not make sense.

If you see that an LLC makes sense, then you need to figure out if you should elect S corporation as your tax choice of entity or retain the default classification, disregarded entity. If a corporation, then you’ll almost always select S corporation, but check out the tax choice of entity post to make an informed decision.

Step 2: Pick your Tax Law Entity

The two most common entity choices for single-owner businesses are:
LLC + Disregarded Entity;
LLC + S corporation.

If you chose corporation for your state law entity, unless you’re a Startup, the vast majority of time you’d select S corporation. For that reason, this post examines what happens the vast majority of time -- an LLC selecting either a Disregarded Entity or S corporation as its tax choice of entity.

Most Common Approach

Here’s the most common tax entity approach for single-owner Small Businesses: they start out as an LLC taxed as a disregarded entity, then when they reach a point where they can pay themselves what the IRS would consider a reasonable salary and still have profits left over, they remain but an LLC but elect S corporation tax status.

A lot to unpack, but it will all make sense. Here’s some steps to walk you through the process.

First, determine your reasonable salary

Before you can determine what tax entity makes more sense between S corporation and disregarded entity, you’ll want to know what you would say the IRS would deem to be your reasonable salary.

The IRS gives you a lot of factors to consider (can see them all here), but in general, your reasonable pay is the “amount that a similar business would pay for the same or similar services.” In other words, determine what services you’re offering that, if you offered them to another employer, you would be paid $X for them. That’s your reasonable pay.

One nice tip the IRS offers is to use your public library, which might have reference sources that provide averages of compensation paid for various types of services. Or you can do an online search at sites like salary.com, glassdoor.com, or payscale.com.

Second, depending on salary, consider being taxed as disregarded entity

Running your company taxed as an S corporation is more complex. Once you’re an S corporation, your taxes get more complex, and you have to treat yourself as an employee. Many LLCs taxed as disregarded entities can handle their own taxes.

So, it makes sense for most businesses to initially be taxed as a disregarded entity, then when it makes financial sense, convert to an S Corp.

Why? It’s all a balancing act. There’s a lot more work with S corps and the tax advantages don’t kick in for almost any business until the business is profitable. Why is that?

Self-employment taxes

It’s all about self-employment taxes. LLCs taxed as disregarded entities have to pay self-employment taxes on all net earnings.

The self-employment tax rate is 15.3% and it’s divided into two parts. The first part is for social security and it’s imposed on all your net earnings up to $128,400 at a rate of 12.4% (the cap on the social security portion of self-employment taxes is tied to inflation, so it usually goes up a little each year). The second part is for Medicare and it’s imposed on all your net earnings without a cap at a rate of 2.9%.

But S corporations don’t pay self-employment taxes (or at least, not exactly). They withhold Social Security taxes at a rate of 6.2% and Medicare taxes at a rate of 1.45% from their employees’ paychecks and also have to match that amount by paying it to the IRS. So the combined taxes for Social Security and Medicare paid by the employee and the company is 15.3%—the same as self-employment taxes.

S corporation tax savings come into play if revenue is high and you’re profitable
The tax savings come from the fact that the S Corp only has to pay self-employment taxes on the reasonable salary the owner pays themselves. If there are profits after all expenses and a reasonable salary has been paid, then the S Corp only pays the ordinary income tax on those profits, not the additional self-employment taxes.

If you’re not profitable (i.e., if your business’s revenue isn’t greater than your expenses, which include your reasonable salary paid), then if you elect to be an S corporation, you’ll incur more fees, probably have to hire a CPA to prepare your corporate income tax return, have to run payroll, and other tasks that wouldn’t necessarily be required if you were simply a disregarded entity.

Also if you’re not profitable, you have more opportunities to take a “loss” to offset other income from your business if you’re a disregarded entity v. being an S corp.

But if you are profitable, then S corps start to make more sense. Some CPAs estimate that if you’re self-employed and your business generates $75,000 or more, then an S corp election would be smart. Others say $100,000.

Third, an important takeaway

Lastly, you should know that you can always convert your LLC taxed as a disregarded entity into an LLC taxed as an S corporation later. Many businesses starting off just want to get things running, aren’t sure how profitable they’ll be, and want to do whatever is simplest to start.

Then, after a year or two (if ever), if they become profitable, they’ll elect to be taxed as an S corporation for the following tax year. You can elect to begin being taxed as an S corporation in any year after you start your business, although there are deadlines for when you have to make the election in order for it to be effective in any given year.

To make an S Corp election, you file a Form 2553 with the IRS (explained in our S corporation section). If you want to elect S Corp status for the current tax year, you need to make the election in the first two months and 15 days of that year. If you want to make the election for next year, you can file it anytime in the current year.

To get more guidance, including a look at what state is best to form your LLC or corporation in, check out our LLC vs. S Corp vs. C Corp ultimate guide.

Chris Daming, J.D., LL.M.

Written by Chris Daming, J.D., LL.M.

Chris is the founder and CEO of LegalGPS. Previously, he served in the Army (82nd Airborne), then went to law school and got his J.D. and LL.M. He practiced law and ran the Startup Legal law firm before founding LegalGPS.

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