S Corp vs LLC: Which Offers Better Tax Advantages for Small Businesses?

As a new business owner, the complexities of taxes can feel like stumbling through a dark maze. You’re eager to launch your venture, but the looming uncertainty of tax obligations casts a shadow of doubt.

At Patrick Accounting, we understand the apprehension and confusion that come with starting a small business because we were once in your shoes. Now, we’ve helped hundreds of businesses make more money and keep more of it through our strategic and proactive approach.

By the end of this article, you’ll understand whether an S Corp or LLC is better for taxes, the specific tax benefits of each, and how their tax implications directly compare—empowering you to make the best choice for your small business.

Understanding S Corporations and Limited Liability Companies (LLCs)

Before diving into the tax advantages, let’s clarify what S Corporations and LLCs entail.

S Corporations

Think of an S Corporation as a hybrid entity that combines aspects of a corporation and a partnership. It provides liability protection for its shareholders while allowing pass-through taxation.

LLCs

On the other hand, an LLC offers similar liability protection but with more flexibility in management and taxation while still allowing pass-through taxation.

What is Pass-Through Taxation?

Good question! This means that the entity (the S Corporation or LLC) doesn’t actually pay the tax, instead, it provides information to the S Corporation shareholder or the LLC member (think partners) to report their share of the income from the entity on their respective tax return.

Taxation Overview for S Corporations

S Corp Tax Advantages

S Corporations enjoy pass-through taxation, meaning business profits and losses are reported on the shareholder’s tax returns. This structure can potentially lead to tax savings, as profits are not subject to self-employment taxes.

Eligibility Criteria

To qualify as an S Corporation, your business must meet certain requirements, including having no more than 100 shareholders and being a domestic entity.

Taxation Overview for LLCs

LLC Tax Advantages

Like S Corporations, LLCs also benefit from pass-through taxation, avoiding double taxation at the entity and individual levels. Additionally, LLCs offer flexibility in tax treatment, allowing members to choose how they want to be taxed.

Eligibility Criteria

LLCs have fewer restrictions compared to S Corporations, making them an attractive option for small businesses. However, it’s essential to comply with state regulations regarding formation and operation.

Head-to-Head Comparison: Tax Advantages

Income Taxation

Both S Corporations and LLCs pass business profits and losses through to their owners’ personal tax returns. However, S Corporation shareholders may receive additional tax savings by avoiding self-employment taxes on distributions.

Self-Employment Taxes

S Corporation owners who are actively involved in the business may receive a portion of their income as distributions, which are not subject to self-employment taxes. LLC members, on the other hand, are typically subject to self-employment taxes on all income.

Tax Deductions and Credits

Both entity types offer opportunities for tax deductions and credits, such as business expenses, retirement contributions, and healthcare costs. However, the specific deductions available may vary depending on the structure and individual circumstances.

Additional Factors to Consider When Deciding Between an S Corp or LLC

Administrative Requirements

S Corporations generally have stricter administrative requirements, including holding regular meetings, maintaining corporate records, and adhering to formalities.

LLCs offer more flexibility in this regard, with fewer formalities and paperwork.

Flexibility in Ownership and Management

LLCs provide greater flexibility in ownership and management structures, allowing for different classes of membership and customizable operating agreements.

S Corporations have limitations on ownership, with restrictions on the types of shareholders and the number allowed.

Legal Liability Protection

Both S Corporations and LLCs offer limited liability protection, shielding owners’ personal assets from business debts and liabilities. This protection is crucial for safeguarding your personal finances in the event of lawsuits or bankruptcy.

Growth Plans

When considering future growth and expansion, LLCs may offer more flexibility than S Corporations. LLCs can easily add or remove members, change ownership structures, and adapt to evolving business needs without the same level of complexity as S Corporations.

State-Specific Factors

It’s vital to recognize that the tax landscape varies by state. Certain states may impose additional taxes or regulations that influence the comparative advantage of S Corps and LLCs.

In Tennessee, for example, we have an excise tax. This is essentially a profit tax. Profits from an S Corporation are taxed at 6.5%. This often limits the tax advantage to choosing to be an S Corporation in Tennessee. In Tennessee, income that is subject to self-employment tax is not taxable for TN excise tax.

As we mentioned above LLC income is subject to self-employment tax. Therefore LLCs don’t typically pay excise tax on their income. As you can see this is where things can get a little murky.

We highly recommend you have a conversation with your accountant or attorney before deciding how you want your legal entity set up. It’s common online to read that a small business should always be an S Corp. Unfortunately, you shouldn’t believe everything you read online.

Owner Compensation Treatment

S Corps and LLCs mandate distinct approaches to owner compensation. S Corp shareholders must receive “reasonable compensation” for their services, subject to employment taxes. In other words, the S Corp shareholders need to be on the S Corporation’s payroll and pay themselves like other employees.

In contrast, LLC members have more flexibility in structuring their compensation, potentially reducing tax liabilities. An LLC member can pay themselves out of the profits of the LLC by simply taking a draw against income.

If there is a disparity in roles within the LLC you may see that one member may receive a “guaranteed payment”. This allows for profits to be allocated differently based on the work being done within the LLC.

Legal Protection and Exit Strategies

Beyond tax considerations, S Corps and LLCs offer differing degrees of legal protection and avenues for owner compensation upon entity sale.

While both entities shield personal assets from business liabilities, the mechanisms for asset protection and sale proceeds distribution may vary.

Making the Right Choice for Your Business

Both S Corporations and LLCs offer distinct tax advantages for small business owners. While S Corporations may provide potential tax savings through pass-through taxation and distribution strategies, LLCs offer flexibility and simplicity in management and growth.

Ultimately, the best choice depends on your specific business goals, financial situation, and long-term plans. If you’re opening a business for the first time, you’ll want to meet with a lawyer and establish an operating agreement and seek the counsel of a certified public accountant to determine which entity structure is best for your specific business and specific needs.

One essential aspect that complements the choice of business structure is understanding how to pay yourself as the business owner. The way you choose to compensate yourself can have significant implications for your personal finances and your business’s financial health. Explore best practices on “How to Pay Yourself as a Business Owner”.