Whether you’re just starting a business or thinking of changing your business structure, a common first step is comparing the LLC vs. the S corporation. While a limited liability company and an S corporation share some characteristics, they also have distinct differences. Get familiar with each before deciding which might be right for you.
The similarities of LLCs and S Corps
LLCs and S corps have much in common:
- Limited liability protection. The owners of LLCs and corporations are not personally responsible for business debts and liabilities. Instead, the LLC or the S corp, as the owner of the business, is responsible for its debts and liabilities.
- Separate entities. Both are separate legal entities created by a state filing. However, they are formed under and governed by very different state business entity statutes
- Pass-through taxation. Both are pass-through tax entities. (Although an LLC can choose not to be taxed as pass-through if the owners so choose). With pass-through taxation, no income taxes are paid at the business level. Business profit or loss is passed-through to owners’ personal tax returns. Any necessary tax is reported and paid at the individual level.
- Ongoing state compliance requirements. Both are subject to certain obligations imposed by the state corporation and LLC statutes, such as having to appoint and maintain a registered agent, filing annual reports and paying annual fees, notifying the state of certain changes such as a change of name, registered agent or entity type and having to qualify to do business in states outside of the formation state.
Differences in ownership and formalities
Ownership. The IRS rules restrict S corporation ownership, but not that of limited liability companies. IRS restrictions include the following:
- LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners).
- Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders.
- S corporations cannot be owned by corporations, LLCs, partnerships or many trusts. This is not the case for LLCs.
- LLCs are allowed to have subsidiaries without restriction.
- S corporations cannot issue classes of stock with different financial rights – such as giving some shareholders a preference to distributions over other shareholders. LLCs are not subject to similar restrictions.
Ongoing formalities. Corporation laws have more mandatory requirements regarding how a corporation is to be managed than LLC laws. Therefore, S corporations face more extensive internal formalities. While LLCs are not required to, some advisers recommend that they too follow internal formalities.
- Required formalities for S corporations include: Adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.
- Recommended formalities for LLCs include: Adopting an operating agreement, issuing membership shares, holding and documenting annual member meetings (and manager meetings, if the LLC is manager-managed), and documenting all major company decisions.
Differences in management
- Owners of an LLC can choose to have members (owners) or managers manage the LLC. When members manage an LLC, the LLC is much like a partnership (or a sole proprietorship if there is only one member). If run by managers, the LLC more closely resembles a corporation as members will not be involved in the daily business decisions.
- S corps have directors and officers. The board of directors oversees corporate affairs and handles major decisions but not daily operations. Instead, directors elect officers who manage daily business affairs. Shareholders do not manage the business and affairs.
Rather than give you just a three sentence answer to this question, however, let me guess about where the question comes from... and then let me provide a bit of elaboration about how the tax accounting works when an S corporation becomes a member in an LLC.
LLC Membership (or Ownership) Only Seems Wrong
First of all, let me say this: I'm going to guess that people who ask this have heard that S corporations have very strict rules about who can be a shareholder in the S corp. And that's true. But there aren't strict rules about what the s corp can itself own.
Accordingly, while a partnership or an LLC taxed as a partnership can't own an S corporation, an S corporation can own an interest in a partnership or an LLC taxed as a partnership.
Similarly, while a corporation can't in almost all situations own an S corp, an S corp can own a corporation.
Sometimes people really struggle with this answer, so let me say this just one more way: Just because there's a rule that says A can't own B doesn't mean that B can't own A.
Tip: If you want more information about who can and can't be an S corporation owner, see this FAQ article: Who Can Be an S Corporation Shareholder?
Accounting for LLCs Owned by S Corporation Members
How an LLC owned by a S corporation gets treated for tax accounting purposes, however, varies depending on how the LLC is treated.
For example, if an LLC is only owned by single S corporation, the LLC is disregarded if it hasn't made an election to be treated as a corporation.
Just so you know, "disregardization" means the LLC's income and deductions just get added to the S corporation's other income and deductions. For all practical purposes, the LLC "disappears" as a taxable or tax reporting entity.
If an LLC is owned by several members and the LLC has not made an election to itself be treated as a corporation, then the LLC is treated as a partnership. This means that the LLC will prepare and file a partnership tax return. Each of the partners or members in the LLC (including any S corporation members) will receive a K-1 from the LLC partnership. And the K-1's income and deductions will be reported on the member's regular tax return.
If an LLC owned by an S corporation has made an election to be treated as a corporation, the LLC files a corporation tax return. But the taxes on any LLC income get paid with the regular 1120 C corporation tax return. The S corporation's accounting and taxes probably aren't affected by what's happening inside the "LLC taxed as a corporation." Essentially, the "LLC taxed as a corporation" is just another "investment" owned by the "parent" corporation.
Let me just for sake of thoroughness mention a related wrinkle: An LLC owned by a single S corporation could also be treated as a Qualified Subchapter S Subsidiary (also known as a QSUB) if the LLC and the member file the appropriate paperwork and if the LLC had prior to acquiring the S corporation member been treated as an S corporation. In this case, the QSUB's income and deductions just get reported on the "parent" S corporation's return. (Check out this FAQ article if you more to learn more.)
A Related Question: Can an LLC Own an S Corp Then?
Not to go off on a wild goose chase here, but while we're on the subject of whether an s corporation can own an LLC, let me discuss the flip-flopped situation: Can an LLC own an s corp?
The answer to this question is sort of hinted at in the preceding paragraphs. As noted, s corporations have pretty strict rules about who can and can't be a shareholder. Partnerships and corporations can't, for example, be shareholders. U.S. citizens and permanent residents (and a handful of other entities) can.
So here's what this means: If an LLC has multiple owners (or members) and is therefore treated as a partnership (this would be the default), that LLC can't own shares in an S corporation. Why? Because a partnership isn't an eligible s corp shareholder. Period.
The same rule holds true for corporations, too. A corporation can't be an S corp shareholder. So an LLC treated for tax purposes as a corporation can't own an S corporation.
Things get a little trickier if you're talking about a single member LLC that's not made an election to be treated as a corporation... and here's why: Such a single member LLC is disregarded or ignored for tax accounting purposes. So that means the real question is whether the single member LLC's owner is an eligible s corporation shareholder. If the member is, then the LLC can be an eligible s corp shareholder. For example, if a single member LLC is owned by a U.S. citizen or permanent resident (both eligible shareholders), then the LLC can own shares in the s corporation. No problem.
However, if the single member LLC is owned by someone or something that is not an eligible shareholder--like a nonresident alien or a partnership or a corporation--then the single member LLC can't own shares.
Want a Downloadable Kit for Setting Up an LLC?
A quick, tangential point: If you're interested in setting up an LLC for use with an S corporation, you may be interested to know that just as we publish downloadable kits for setting up S corporations, we also publish downloadable kits for setting up limited liability companies. You grab the LLC kits, however, from another website. Click here if you are interested.
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