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S Corp vs. LLC: Which Business Entity is Best?

When deciding between an S corp and an LLC for your business, there are many pros and cons to consider for each.

Eager to start your own small business?

Becoming an entrepreneur is exciting, but all business owners need to set up some kind of an entity before launching their new enterprise. This is a process known as business incorporation. You will need to formally incorporate your business in order to legally own and operate the company bank account, deal with customers, enter into contractual agreements and so forth.

What's confusing to most new entrepreneurs is the difference between the types of business entities available:

deciding between an LLC and an S Corp

There is a reason a significant portion of any new lawyer' education centers around these kinds of business entities. Incorporation can be a very complex area of law and finance.

Two of the most popular business entities are S Corps and LLCs. An S Corp is a corporation formed under subchapter 'S' of the Internal Revenue Code. An LLC is essentially a combination of a partnership and a corporation with some advantages and fewer disadvantages. Continue reading for more details about these two types of business incorporation.

Why is Business Incorporation Necessary?

The reason business entities exist is to shield their owners or shareholders from the liability of launching a large-scale enterprise.

Sailing ships were some of the world's first ventures where company owners needed such protection. If the ship's voyage failed, the owners of the corporation wanted to avoid being held personally liable for the cost of the ship or its cargo. Without such protection, it would have been impossible for all but the wealthiest individuals to finance voyages.

In a modern context, business incorporation creates a separate legal entity. In the eyes of the law, the new entity is a "person." Though fictional, a business entity is still capable of entering into its own contractual agreements, having its own bank account, filing its own tax returns and, for all legal purposes, being distinct from its owners.

A business entity can file a lawsuit, be a defendant in a lawsuit and retain its own legal counsel. It can do many of the same things than individual person can do, but it has one very important distinction: a corporation can shield shareholders from any liability for the corporation's activities.

The Case for S Corp

A corporation filed under subchapter 'S' of the Internal Revenue Code shares all these features listed along with a few important restrictions.

Ultimately, an S corporation is a corporate business entity that is taxed like a partnership. Income passes through the corporate entity without the corporation itself being taxed. Its owners file the company's income on their personal returns where it is taxed at the shareholder's rate.

(C corporations, or c corps, by contrast, are themselves taxed before they issue dividends to shareholders which are, once again, taxed as dividend income.)

Corporations are regulated by state governments which place restrictions on S corps due to their nature. S corps cannot have foreign investors, can only have a limited number of shareholders and, unlike other kinds of corporations, may only have a limited number of share types.

Pros of S Corps

Cons of S Corps

  • Asset protection
  • Pass-through taxation
  • Perpetual operation
  • Cash accounting method
  • Credibility
  • Stock ownership restrictions
  • Closer IRS scrutiny
  • Less ownership structure flexibility

The Case for LLCs

An LLC is similar to a corporation but has far fewer paperwork requirements. It is quite a bit less formal and its organization and may or may not have the kinds of ownership restrictions that an S corp would have.

Like any corporation, an LLC shields its owners from liability for the operations or activities of the company. A limited liability company can have its own bank account, enter into contracts, retain legal counsel and launch or defend against legal action.

An LLC's income is taxed on a pass-through basis similar to an S corp, but slightly different. Any money earned by the company is not taxed at the company level, but is instead considered income of the company owners. This income is distributed according to the terms of an operating agreement or through an ownership contract.

Also, if a limited liability company is only owned by one person, in most cases it is considered an "alter ego" of the single owner and therefore doesn't need to file its own tax return. Since most LLCs have no tax liability of their own, it stands to reason all of their obligations would be subsumed in the ownership's filings.

Pros of LLCs

Cons of LLCs

  • Asset protection
  • Pass-through taxation
  • Less paperwork & requirements
  • Flexible organizational structure
  • Fewer restrictions
  • Ongoing formation expenses
  • Harder to transfer ownership
  • Less legal precedent

Which is the Best Choice: S Corp or LLC?

LLCs have far fewer restrictions on their ownership structures. S corps cannot be owned by other corporations, and they can only have a small number of shareholders. They can't have foreign owners, and there are considerable restrictions on their ability to form subsidiaries or hold equity stakes in them.

There are no such restrictions on an LLC. A limited liability company can form unlimited subsidiaries and can be owned by practically any combination of owners in nearly any combination of equity shares.

One of the more popular ownership structures of an LLC is the appointment of a manager with only a minimal equity stake and the remainder of the company owned by beneficiaries. For example, this structure is often used by parents to operate companies on behalf of their children.

This isn't to say S corporations don't have their place. Corporations are perpetual unless the shareholders vote to dissolve them. In some states, LLCs must conclude after a certain amount of time. Withdrawal of membership can also trigger situations that require the limited liability company to close and re-open under new owners.

Tax treatment for an S corp can also be more favorable since shareholders can employ and pay themselves a standard salary which can be taxed like standard payroll compensation.

As with any decision to form a legal entity, new enterprise or small business, it is always recommended to seek the services of a qualified business incorporation expert.

It is often advantageous to find professional advisors who are experienced in the process of setting up new businesses and making certain all the necessary documents are filed and in order.

Keeping those advisors around to guide the new company is also usually the best course of action as there are legal obligations for both corporations and limited liability companies throughout their existence.

To learn more about forming your own business or choosing the entity that is right for you, head to our Maxfilings Business Formation Guide. Here are some related articles we think you will find helpful: