Choosing a business structure is one of the decisions many entrepreneurs face when starting or growing a business.
Two terms that often create confusion are LLC and S corporation.
The important thing to understand is that an LLC and an S corporation are not necessarily two competing types of businesses.
An LLC is a legal business structure created under state law. S corporation is a federal tax election that certain eligible businesses can choose.
That distinction matters.
What Is an LLC?
LLC stands for Limited Liability Company.
An LLC is a business structure recognized under state law. Many small business owners choose an LLC because it can provide liability protection while offering flexibility in how the business is taxed.
For federal tax purposes, a single-member LLC is generally treated as a disregarded entity unless it makes a different election. A multi-member LLC is generally treated as a partnership unless it makes another election.
This means an LLC does not automatically have one specific federal tax treatment.
What Is an S Corporation?
An S corporation is a federal tax classification.
An eligible corporation or LLC may elect to be taxed as an S corporation by making an election with the IRS.
One reason some business owners consider S corporation taxation is the potential difference in how business income and owner compensation are treated for federal tax purposes.
However, S corporation status also creates additional responsibilities.
For example, an owner who works in an S corporation generally needs to receive reasonable compensation through payroll before taking certain distributions.
Why Do Business Owners Consider S Corporation Taxation?
The potential tax advantages are one reason an established business owner might consider an S corporation election.
However, the decision should not be based on one tax calculation alone.
S corporations can involve additional payroll requirements, tax filings, recordkeeping, and administrative costs.
The potential tax savings need to be weighed against those additional responsibilities.
When Does an LLC Make Sense?
An LLC may be a good fit for many small businesses because of its flexibility.
For some businesses, the simplicity of the default tax treatment may be appropriate.
For others, an LLC may provide the legal structure they want while allowing them to consider an S corporation tax election later.
The best choice depends on the business and the owner’s circumstances.
When Should You Consider an S Corporation Election?
There is no universal income level where every business should become an S corporation.
Instead, consider the entire picture.
Factors can include:
- Business profit
- Owner compensation
- Payroll costs
- Tax savings
- Accounting costs
- Administrative responsibilities
- Business growth
- Long-term goals
A business that produces consistent profit may be in a different position from a new business with unpredictable income.
Don’t Make the Decision Based on a Rule of Thumb
You may hear advice that says every business earning a certain amount should become an S corporation.
Business decisions are rarely that simple.
A tax election that works well for one business may not make sense for another.
The right approach is to look at your actual numbers and consider the costs and potential benefits.
What About Changing From an LLC to an S-Corp?
You do not necessarily have to change the legal structure of your LLC to be taxed as an S corporation.
An LLC may be able to elect S corporation tax treatment if it meets the requirements.
The timing of an S corporation election also matters. The IRS has specific rules regarding when the election must be made.
This is one reason it is better to discuss the decision before tax deadlines arrive.
Talk With Your Tax Professional Before Making a Change
Business entity selection can have tax, legal, payroll, and administrative consequences.
An accountant or tax professional can help you understand the tax side of the decision, while an attorney can advise you regarding legal considerations.
At Transactions, LLC, we can help business owners evaluate the tax considerations of entity selection and understand what an S corporation election could mean for their situation.
The goal isn’t to choose the structure with the most appealing label. It is to choose an approach that makes sense for your business.