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When might an S corporation be a good idea for a business?

On Behalf of | Jan 11, 2024 | business formation & planning

Limited Liability Companies are the go-to choice for many business owners who want the benefits of liability protection without the formalities of a corporation. In fact, a 2020 report from the Internal Revenue Service showed that over 70% of business partnerships in the United States are LLCs.

However, LLCs might not be the perfect fit for every company. Under certain circumstances, electing to become an S corporation may be a wise move.

How does an S corp differ from an LLC?

An S corp is a business structure that provides liability protection just like an LLC, but with a few tax benefits that corporations enjoy. Some of their key differences are:

  • Forming an LLC tends to be simpler and more flexible. An LLC does not have a limit to the number of members who form the company, while an S corp can have no more than 100 shareholders, all of whom must be U.S. citizens or residents.
  • LLCs have a more flexible management structure, as members can manage the company themselves or designate managers. In contrast, an S corp follows a more traditional corporate structure with a board of directors and officers.
  • S corps have more restrictions on ownership, which can be a long-term protection. For example, C corps, other S corps, LLCs, partnerships or nonresident aliens cannot own S corps.
  • S corps can issue only one class of stock. LLCs can offer various classes of interest.

However, both LLCs and S corps are pass-through entities. The difference is that LLC members must pay self-employment taxes on the business’s entire net income. In S corps, only the salary of owner-employees is subject to employment tax. The remaining income as distribution is not subject to self-employment tax.

What are the advantages of an S corp?

The IRS does not tax an S corp at the corporate level. Owners also pay a lesser amount in payroll taxes that come with running an LLC. Additionally, unlike LLCs, S corps can give their employees and owners a salary, with only the salary amount being subject to Social Security and Medicare tax.

A common reason to convert from an LLC to an S corp is that the LLC has grown to a point where the savings on payroll taxes that the S corp generates will exceed the costs of administration. If an LLC generates enough profit to justify a reasonable salary for owners and provide income tax savings, it might benefit the owners by becoming an S corporation.

Business formation provides protection for personal assets and tax benefits. While LLCs are popular and can be easier to set up, business partners should examine whether an S corp could offer even more advantages.