The distinction between a Limited Liability Company (LLC) and an S Corporation (S corp) often confuses small business owners, but the difference is clear: the LLC is the legal entity, and the S corp is the tax election.
The LLC: The Legal Entity
An LLC is a state-level legal entity that has become the standard choice for small businesses since their popularization in the early nineteen nineties. They are generally much easier to deal with than corporations because an LLC essentially arises out of a contract (the operating agreement), while a corporation deals with personal property shares and is more cumbersome.
When an LLC is formed, the IRS defaults its tax status based on its membership:
- A single-member LLC defaults to a disregarded entity (taxed like a sole proprietorship).
- A multiple-member LLC defaults to a partnership.
In both default cases, the LLC is a pass-through entity.
The S Corp: The Tax Election
An S corp is not a legal entity in itself; it is a tax classification elected with the IRS. A business owner does not need to form a Texas corporation to have an S corp; they simply form the LLC and then elect S corp status.
The main reason clients elect S corp status is for specific tax advantages, primarily to avoid certain employment taxes, namely Social Security and Medicare. Owners attempt to achieve this by paying themselves a low salary (which is taxed) and taking the majority of their income as a distribution (which avoids the self-employment tax). This is a highly audited practice by the IRS, but many people utilize it.
Avoiding the C Corporation Trap
It is very rare for small business owners to form a traditional Texas corporation. If a traditional corporation is formed, the IRS defaults its status to a C Corporation (C corp).
C corporations are largely avoided by small businesses because the income gets taxed twice: once at the corporate level and again when profits are distributed to the shareholders. This double taxation makes the C corp structure financially inefficient for most small-scale entrepreneurs.
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