You’ve likely heard the terms LLC and S-corporation tossed around in business. The two are often discussed in conjunction with one another as they are the most common forms of ownership for small businesses.

If you are a new entrepreneur or are growing your business, becoming an LLC or an S-corporation may be the best next step. However, there are some distinctions between the two entities that are important to consider.

What is an LLC?

A limited liability company (LLC) is a newer type of legal business entity that protects the business owners’ (or “members”) personal assets from creditors. If the LLC has two or more members, it will file as a partnership and is considered a pass-through entity, which means members report profits or losses from the LLC on their personal tax returns. The members must pay a self-employment tax on any profits earned, which in 2021 is 15.3% on the first $142,800 of profits, and 2.9% on anything above that.

If it is a single-member LLC, it is referred to as a “disregarded entity” and treated as a sole proprietorship. All the profits of the sole proprietorship are subject to self-employment tax.

What is an S-corporation?

An S-corporation (S-corp) is a legal corporation in the eyes of the state it is created in, with the “S” representing an elected tax status. Like an LLC, an S-corp is a pass-through entity that is not taxed at the corporate level.

Business owners of an S-corp are referred to as shareholders and are considered employees that must pay themselves a reasonable salary. This salary is subject to self-employment taxes but the remaining residual profits of the S-corp are not, unlike the LLC. Shareholders will be taxed on their individual portion of the profits on their personal income tax return.

LLCs can also elect to be taxed as an S-corp. When the timing is right based on an analysis of salary versus profits, electing an S-corp status may be most appropriate.

Which is better for my business?

You must either be an LLC or a corporation in order to elect to be taxed as an S-corp. For brand new businesses and entrepreneurs, filing as an LLC is generally a good place to start, but it all depends on your particular circumstance. The LLC provides you with similar legal protections of a corporation, but a greater ability to claim certain tax write-offs.

However, once your business grows to a certain profit level, it may be more beneficial to be taxed as an S-corp. As your profits grow, so does the amount of self-employment taxes you would have to pay on total earnings as an LLC. When your company profits before considering a salary are greater than the salary that would be deemed reasonable by the IRS — and will continue to be so in the future — then businesses may want to elect S-corp status . Every dollar of residual profits not subject to self-employment taxes as an S-corp will save you 15.3 cents.

How do I file as an LLC or S-corp?

According to the IRS, an LLC or C-corp may file as an S-corp if they meet certain requirements such as having no more than 100 shareholders, being a domestic corporation, and having only one class of stock. From there, the corporation must submit Form 2553 signed by all of its shareholders.

LLCs and corporations can be legally created in any state through the department of that state which creates those entities. In Colorado, like most states, you can register through the Secretary of State’s website. You will want to check your state’s guidelines in order to take the appropriate steps.

If you have further questions about becoming an LLC or filing as an S-corp, it can be helpful to talk with your CPA. At Wych Tax, we offer free consultations outside of tax season, so give us a call at 970-223-0792 or visit our website for more info.