When starting a new business, it is important to consider the tax and legal implications of the type of business you are operating. 

For example, a business can register as an LLC or corporation and have more flexibility when it comes to tax; both can choose to be taxed like an S Corporation. However, if your business is incorporated, you might face double taxation. You’re also limited in how you can structure your business in terms of organization. 

Deciding on how to classify your business is difficult because it determines how your business will operate year over year and it may result in high taxes. 

In general, there are advantages to being an LLC and filing your LLC or corporation as an S Corporation. 


What is an LLC?

An LLC stands for limited liability company and it is an entity with limited liability so that the personal assets of the owners and investors in that company are protected and the owners or investors (called members) are not personally liable for the debts and liabilities that a company incurs. 

When a business becomes an LLC, they are able to bring on more investors to operate as owners/members to increase the capital of the business, and further provide assets to those investors. Without limited liability protection, a member’s home, vehicles, and personal assets can be used as collateral if the business owes a debt following a bankruptcy or lawsuit. Because they are offered protection with an LLC, outsourced investors are more likely to invest in a company.

LLC ownership is not restricted in the same way that a sole proprietorship is restricted. An LLC can be owned by an individual, corporation, foreign investor, a foreign entity, or another LLC. Contrarily, a sole proprietorship must be owned by an individual, and can only operate under a different business name with a “Doing Business As” (DBA) filing. 

An LLC is a pass-through taxable entity so the business’s profits pass through the members (i.e., owners) as opposed to paying its own corporate taxes like a corporation. The profits and losses are reported on the member’s individual tax returns and losses and operating costs can be deducted on personal tax returns. The tax rate depends on the income of the owner, similar to when you file as a sole proprietor or individual. State regulations vary; some LLCs may need to pay self-employment taxes and franchise taxes.


What is S Corporation?

An S Corporation is a classification that the IRS uses to describe a business for tax purposes. An S Corporation is also known as an S subchapter. If your company is an LLC or a domestic corporation with less than 100 shareholders with only one class of stock, you can file as an S Corporation and be taxed like a partnership.

Similar to an LLC, an S Corporation, or an S Corp, is considered a flow-through taxable entity so that the entity can avoid double taxation. S Corp dividends are not subjected to employment tax and can provide many tax benefits.

So if a corporation files its taxes under Subchapter S, then the company can pass its business income, credits, losses, and deductions through to the shareholders. 


Is an S Corp a Legal Entity?

Some people might think that an S Corp is a legal entity but it is not, it is only a tax entity. Therefore, when you are creating a business, you will need to decide on what type of business entity the company is before deciding on the type of tax entity. For example, your business can operate as a sole proprietorship, a limited liability company or partnership, and a corporation. 

Whatever the result, you must file the required paperwork in the state in which the business will operate and continue to practice the requirements for that type of business entity. When it comes to tax time, a domestic corporation with less than 100 shareholders and only one class of stock can consider filing as an S Corp to avoid double taxation. 

Investors in an S Corp will receive a dividend and distribution rights but they are not required to have voting rights. In order to file as S Corp, the business must file papers to become incorporated and take on other duties and fees, but these are often minimal. For example, an S Corporation owner will need to file an Articles of Incorporation, pay incorporation fees, and obtain a registered agent. 


Advantages of an LLC Filing as an S Corp

For LLCs, there is some benefit to filing as an S Corp. To start, when filing as an S Corp, an LLC can begin to establish credibility since the owner shows a more formal commitment to the company. Therefore, the business will be able to operate with the flexibility of an LLC as well as the perception of a Corporation without needing to pay federal taxes at the entity level. 

LLCs can also transfer interest into an S Corporation an avoid adverse tax consequences, complex accounting rules, and adjustments based on property. Employees in an S Corporation can be both salary-earners and shareholders. They can also receive a tax-free corporate dividend. 

While there are some exceptions to these rules, filing as an S Corp, in general, is beneficial to small businesses and LLCs, as well as small corporations. 


Disadvantages of an LLC Filing as an S Corp

While not necessarily a downside, a business that files under an S Corp needs to pay reasonable salaries to those employees who are also shareholders (and not pay a low salary to an employee based on the assumption that they will receive a shareholder benefit). 

Because an S Corp can classify a salary as a corporation distribution to avoid payroll taxes, the IRS will scrutinize an S Corp more closely. Therefore, companies who file under S Corp need to be doing so to receive the benefit of legally avoiding payroll taxes but not as a way to pay employees less. 

When submitting under S Corp, you also need to develop an Articles of Incorporation with the Secretary of State, obtain a registered agent for the business, and pay the fees associated with incorporation. This might increase the amount of responsibility annually, such as filing reports, paying a franchise tax, and other fees. However, these charges may be minimal and can often be deducted as a business expense.