LLC or S-Corp?

By far the question new entrepreneurs ask us the most is whether their new company should be an LLC or an S-Corp. It’s an apples and oranges comparison as I explain and I answer here.

Be An LLC

You form your company at the State level. Each State allows several choices for how the company may be governed and which collection of State laws apply to the company. The main choices are Limited Liability Company (LLC) and corporation. LLC governance is the most flexible, and it is what we recommend in the vast majority of new business formations. LLCs are typically governed directly by their all the owners, but many other structures are available. Governance of corporations is according to a rigid structure of a board of directors that is elected by shareholders.

Under what circumstances should you form a corporation rather than an LLC? The only good answer is that you form a corporation when one or more of the prospective owners demand that the company be a corporation. This is rare, but it may happen if one of the owners is putting up most of the money and just feels more comfortable with the rigid governance structure of a corporation. Also keep in mind that you can always change the governance from LLC to corporation at a later date.

Once you decide how your company is going to be govered, you move on to decide how your company is going to be taxed. That’s where the choices get complicated.

The Company’s Tax Status

Your company may file its taxes with the IRS according to rules that have certain confusing names: Disregarded Entity, Partnership, S-Corp, C-Corp. You must keep in mind that these names apply to sections of the IRS tax code, not to the reality of how a company is formed at the State level or how it is governed under State laws.

Company Was Formed As Corporation

If your company has been created as a corporation (that means your company is governed in a certain way, see section “Be An LLC” above) in any State in the USA, then you have two choices for how the company files its taxes with the IRS:

1. You can choose to have your corporation comply with the rules under the section of IRS code referred to as “C-Corp.” The corporation files a annual tax return and pays its own taxes on its taxable income. If the owners (shareholders) take dividends, then the owners pay tax on the dividends, and the dividend payments are not a deductible expense on the company’s tax return. This situation is referred to as the “double taxation” of dividends.
2. You can choose to have your company comply with the rules under the section of IRS code referred to as “S-Corp.” The corporation must file an annual tax return, but the corporation does not pay taxes directly on its taxable income. Instead the company’s tax return is merely informational, and the company sends its owners a form K-1 which tells each owner how much of the company profit or losses are allocated to that owner. The owners then put that information on Sched E of their personal tax returns and the owners pay taxes on their share of the company’s taxable income. In company that has elected to be treated as an S-Corp, if the owners take dividends, then the owners do not pay additional tax on those dividends. The dividend are already included in the taxable income of the company because the dividend payments are not a deductible expense on the company’s tax return. So unlike a company treated as a C-Corp the owners pay tax only once on dividends.

If you want a corporation to be taxed as an S-Corp, you must file an election with the IRS on form 2553. If you don’t file that election, then by default your corporation will be taxed under the C-Corp rules.

Company Was Formed As LLC

If your company has been created as an LLC (that means your company is governed in a certain way, see section “Be An LLC” above) in any State in the USA, then you have four choices for how the company files its taxes with the IRS:

1. You can choose to have your LLC comply with the rules under the section of IRS code referred to as “C-Corp.” The company must file an annual tax return and the company pays taxes on its taxable income. If the owners (LLC members) take dividends (called “distributions” from an LLC), then the owners pay tax on the dividends, and the dividend payments are not a deductible expense on the company’s tax return. This situation is referred to as the “double taxation” of dividends. This is no different that a company that is formed a the State as a corporation.
2. You can choose to have your LLC comply with the rules under the section of IRS code referred to as “S-Corp.” The company must file an annual tax return but the company does not pay taxes directly on its taxable income. Instead the company’s tax return is merely informational, and the company sends its owners a form K-1 which tells each owner how much of the company profit or loss are allocated to that owner. The owners then put that information on Sched E of their personal tax returns and the owners pay taxes on their share of the company’s income. In company that has elected to be treated as an S-Corp, if the owners take dividends, then the owners do not pay additional tax on those dividends, and the dividend payments are not a deductible expense on the company’s tax return. So unlike a company treated as a C-Corp the owners pay tax only once on dividends. This is no different that a company that is formed at the State as a corporation and has elected to be treated as an S-Corp by the IRS.
3. If you are the only owner of the LLC, you can choose to have your company ignored by the IRS and all of the company’s revenue and expenses will flow directly to your personal tax return on Sched C. The IRS refers to the company as a “disregarded entity” which is the equivalent of a sole-proprietorship. This option is not available to a company that is formed at the State as a corporation.
4. If there are two or more owners of the LLC then you cannot choose “disregarded entity” as your tax status, but you may choose to have your company taxed as a Partnership. There are many complications to the Partnership tax code, but the basic concept is that Partnership taxation is similar to S-Corp taxation, namely the company files an information-only return, issues K-1s to the owners, and each owner pays personal income tax on their individual share of the company’s profit.  This option is not available to a company that is formed at the State as a corporation.

If you want an LLC to be taxed as an S-Corp, you must file an election with the IRS on form 2553. If you want an LLC to be taxed as a C-Corp, you must file an election with the IRS on form 8832. If you don’t file either 2553 or 8832 elections, then the LLC will be treated for tax purposes according to a default rule. If the LLC has a single owner, then by default the LLC is treated as a disregarded entity. If the LLC has two or more members, then by default the LLC is treated as a Partnership.

Summary & Suggestions

You must decide two distinct things: (i) Will your new company be governed as an LLC or a corporation, and (ii) How will your new company be taxed. Don’t conflate these two decisions. Admittedly the names of IRS code sections make this dicotomy difficult to keep separate in your mind, but you must do so.

Our recommendation is that the company be formed as an LLC. If there’s only one member of the LLC, then initially use the “disregarded entity” status with the IRS because it’s the default (so you don’t ahve to do anything special) and because this status makes tax filing simpler. But if there are two or more members, then it’s better to file the election to be taxed under the S-Corp rules than it is to be taxed under the default rules of Partnership. This combination–LLC taxed as S-Corp–allows for the most flexible governance and tax planning in that scenario.

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