“S corp vs LLC” isn’t quite a choice between two entities. An LLC is a type of legal entity. An S corporation is a federal tax status that an LLC or a corporation can elect. So many small businesses are both: an LLC for flexibility and simple governance, taxed as an S corp once the business is profitable. Neither is the right structure for a startup that plans to raise venture capital. That’s a C corporation.
Key takeaways
- An S corp is a tax election, not a separate kind of company.
- An LLC can elect S corp tax treatment and keep its LLC structure and operating agreement.
- S corps have strict ownership rules: no company or fund owners, no non-US owners, and only one class of stock.
- If you plan to raise from venture investors, form a Delaware C corp instead.
How do they compare?
| LLC (default tax treatment) | LLC or corporation taxed as an S corp | C corp | |
| What it is | A legal entity | A tax status elected with the IRS | A legal entity with default corporate tax |
| Federal income tax | Passes through to owners | Passes through to owners | Taxed at the company level, then again on dividends |
| Who can own it | Anyone, including companies and non-US owners | Up to 100 US individuals (and certain trusts and tax-exempt organizations); no companies, funds or non-US owners | Anyone |
| Classes of equity | Flexible | One class of stock (voting differences allowed) | Multiple classes, including preferred |
| Profits interests for team members | Yes, if taxed as a partnership | No | No (uses stock options instead) |
| Qualified small business stock (QSBS) | No | No | Yes, if requirements are met |
| Venture capital | Rarely | No | Standard |
Is an S corp an entity or a tax election?
A tax election. An LLC or a corporation becomes an “S corp” by filing IRS Form 2553. The legal entity doesn’t change. An LLC that elects S status keeps its operating agreement, its members and its managers.
Why do small businesses elect S corp status?
Mainly because of how owners who work in the business are paid. In an LLC taxed as a partnership, active owners generally pay self-employment tax on their share of the profits. In an S corp, owner-employees take a reasonable salary through payroll, and the remaining profit passes through without self-employment tax. The trade-off is running payroll, filing a separate S corp return, and paying for more accounting. Whether it’s worth it depends on how profitable the business is and on your state, so it’s a decision to make with your accountant. Some states and cities, including New York City, don’t fully recognize S status and tax S corps much like C corps.
What if early investors want the losses?
An LLC taxed as a partnership can allocate early losses mostly to the people who put in cash. An S corp has to split losses by shares owned. Whether those losses help any investor depends on their own tax situation, so involve a tax advisor.
Who can’t own an S corp?
S corp shareholders must be US citizens or residents, individuals (or certain trusts, estates and tax-exempt organizations), and there can be no more than 100 of them. That rules out:
- Non-US founders or investors
- Other companies, including a holding company, a fund or a partner’s LLC
If a co-founder lives abroad, or a business partner wants to invest through their company, an S election is off the table. An LLC taxed as a partnership can take both.
How is it managed?
Management follows the legal entity, not the tax election. A corporation has a board and officers. An LLC is run by its members or managers under its operating agreement, whether or not it has elected S status.
What about equity for partners and team members?
An LLC taxed as a partnership can grant profits interests, which give a team member a share of future growth. An S corp can’t. Because it can have only one class of stock, it also can’t sell employees cheaper common stock while investors pay more for preferred, the way most startups do. Everyone pays the same price per share.
Corporations, including S corps, can grant stock options, including incentive stock options. An LLC can’t grant incentive stock options and uses profits interests or other unit-based awards instead.
Is liability protection different?
No. An LLC and a corporation both protect owners from the company’s debts, as long as you keep business and personal finances separate and follow basic formalities. The S election has no effect on liability.
What if I might raise venture capital later?
Then neither is the right structure. Venture funds can’t hold S corp stock, and they rarely invest in LLCs. Many venture funds’ own investors are pension funds, endowments and non-US investors, who don’t want business income from a pass-through company flowing to them. That’s why funds invest in corporations. Founders who expect to raise money form a Delaware C corp from the start, which also opens the door to QSBS. Starting as an LLC keeps that option open: an LLC can usually convert to a C corp tax-free, and the new stock can qualify for QSBS. S corp stock never becomes QSBS, even if the company later drops the election. If you’ve already started as an LLC or an S corp, you can convert. See Converting an LLC to a Corporation and C Corp vs LLC.
Do I still need an operating agreement?
Yes, every LLC needs one, especially with more than one member, and whether or not you elect S status. It should cover ownership, how decisions are made, how profits are allocated, and what happens when a member leaves, dies or wants to sell. If you elect S status, have your accountant review the distribution provisions, because an S corp can’t have uneven economics among owners. See LLC Startup Package.
Related: S Corp vs C Corp · C Corp vs LLC · What Legal Structure Is Best for Your Startup?
