LLC vs. S Corp: Which Offers Better Tax Benefits and Legal Protection?

When deciding between an LLC or S Corp, it’s important to fully understand the implications of each option for both state law and tax law. This is because you could be an LLC or Corporation (both are state law entities) taxed as an S Corporation (a tax law entity). Or you could form an LLC and be taxed under the default rules (i.e. disregarded entity or partnership, depending on how many members you have). Confusing, right? Don’t worry—we cover everything about choosing the best business entity in our comprehensive guide.

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To help you navigate this decision, we’ll break this blog down into two steps:

1. Pick your state law entity
2. Pick your tax law entity

One last thing - here's a handy chart to reference if you get confused. If a business has one owner, you have five choices:

• LLC + Disregarded Entity;
• LLC + C corporation;
• LLC + S corporation;
• Corporation + C corporation; and
• Corporation + S corporation.

Step 1: Pick Your State Law Entity (LLC or Corporation)

For single-owner businesses, you generally have two choices for your state law entity: LLC or Corporation. More often than not, LLCs are the preferred choice for most small businesses. Here’s why:

Why LLCs Are Often Preferred Over Corporations

• Simplicity: LLCs are easier to form than corporations and often preferred, as highlighted in our Sole Proprietorship vs. LLC comparison. They also require fewer ongoing formalities. Corporations are required to hold annual shareholder meetings, elect a board of directors, and maintain detailed corporate records, which can be burdensome for a single-owner business.

• Flexibility: LLCs provide more flexibility in how you manage and operate the business. With corporations, more formalities, like annual meetings and elections, are required, making them more complex and time-consuming.

While LLCs often provide a more straightforward approach, it’s worth noting that some attorneys may recommend a corporation simply because they are more familiar with it. However, unless you have specific reasons for choosing a corporation, an LLC will typically offer a simpler setup and ongoing maintenance process for small businesses.

Corporations Are More Complex

Corporations—especially S Corporations—come with more administrative work. For example, an S Corp must file:

• Form 1120S: The S corporation tax return (informational only, as S Corps are pass-through entities).
• Schedule K-1: To report each shareholder's share of income and deductions to the IRS.
• Employment Forms: Even if you’re the only owner, the IRS considers you an employee, requiring you to file employer forms and pay state employment taxes.

While some of this administrative burden can be outsourced to a payroll service (for around $50/month), it still adds a layer of complexity.

LLCs Offer Comparable or Better Liability Protection

LLCs generally offer the same or better liability protection than corporations. Two key points to consider:

• Corporate Veil: LLCs make it easier to maintain the “corporate veil,” which protects your personal assets from business liabilities. Corporations are required to maintain strict corporate formalities, and failing to do so can lead to “piercing the corporate veil,” which could result in personal liability. LLCs have fewer formal requirements, making it easier to preserve this protection.

• Charging Order Protection: This is like a reverse corporate veil. It protects the business from the personal liabilities of its owners. If an LLC owner has a creditor, that creditor can only place a lien on the owner’s distributions from the LLC, but can’t seize the LLC’s assets or take over the business itself.

One Caveat: LLC Fees Can Vary by State

In some states, LLCs have higher fees than corporations, such as in California, where LLC fees are significantly more expensive. If you’re operating a small or hobby business, these fees might make a corporation more appealing. Always check your state’s fee structure before deciding.

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Step 2: Pick Your Tax Law Entity

Once you’ve selected your state law entity (likely an LLC), the next step is to choose your tax law entity. For most small businesses, the two most common choices are:

1. LLC + Disregarded Entity
2. LLC + S Corporation

If you’ve chosen a corporation as your state law entity, you will almost always select S Corp for tax purposes unless you’re a larger startup with different needs. But since most small businesses are LLCs, let’s focus on whether you should elect to be taxed as a disregarded entity or as an S Corp.

The Most Common Approach

Most small businesses start as LLCs taxed as disregarded entities. As the business grows and becomes more profitable, they then elect to be taxed as an S Corp to take advantage of certain tax benefits. Here’s why:

First: Determine Your "Reasonable Salary"

To determine whether it makes sense to elect S Corp status, you need to know what the IRS would consider a reasonable salary for yourself. The IRS has guidelines, but in general, it’s the amount you would be paid if you were doing similar work for another company.

You can use resources like salary.com, glassdoor.com, or your local public library to get an idea of what a fair salary would be for your role.

Second: Decide Between Disregarded Entity or S Corp Based on Profitability

• Disregarded Entity: If you’re just starting out or not yet profitable, being taxed as a disregarded entity (the default for single-member LLCs) is simpler. You report your business’s income on your personal tax return and avoid the complexity of payroll and corporate tax returns.

• S Corporation: Once you’re profitable, electing S Corp tax status can provide significant tax savings. This is especially true when your business is generating enough income to pay yourself a reasonable salary and still have profits left over.

Why S Corps Save on Taxes

LLCs taxed as disregarded entities pay self-employment taxes on all net earnings (15.3%, which covers Social Security and Medicare). However, with an S Corp, you only pay these taxes on your salary—not on any additional profits. This can lead to substantial tax savings as your business grows.

For example, if your business earns $75,000 or more, many CPAs recommend considering an S Corp election to reduce the self-employment tax burden.

Third: Flexibility in Timing Your S Corp Election

You don’t have to make the decision to elect S Corp status right away. Many businesses start as disregarded entities, then once they become profitable, they elect S Corp status. To initiate the S Corp election process, you’ll need to file Form 2553 with the IRS. You'll also want to update your operating agreement.

The Bottom Line

For many small businesses, the best approach is to start as an LLC taxed as a disregarded entity and transition to an S Corp once the business becomes profitable. This approach allows you to keep things simple in the early stages, while still taking advantage of tax savings when your business starts making money.

If you need more guidance on choosing the right state or tax law entity, check out our comprehensive LLC vs. S Corp vs. C Corp guide.

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Protect your business with our complete legal subscription service, designed by top startup attorneys.

• ✅ Complete Legal Toolkit
• ✅ 100+ Editable Contracts
• ✅ Affordable Legal Guidance
• ✅ Custom Legal Status Report

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