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LLCs and S corps are, in many ways, very similar—they are both pass-through entities, meaning that income derived by both S corporations and LLCs is passed through directly to the owners and reported on the owners’ individual personal income tax returns. With this process, both LLCs and S corps avoid what is known as “double taxation” (a process involved in C corporations during which corporate income is taxed twice: once as corporate tax, and once at the individual level as income tax). They’re also both incorporated entities, legally separate from their individual owners.

But as similar as these two business structures are, there are important differences that you’ll need to be aware of in order to make a solid, informed decision on which entity type is best for you.

LLC vs. S Corp—Ownership Restrictions

S corporations cannot have more than 100 shareholders. Additionally, of those 100 shareholders, all must be either US citizens or resident aliens. Because of this, a cross-section of business types available would show that S corporations are smaller corporations, generally, than C corporations.

LLCs have a much more flexible ownership structure. LLCs do not have shareholders; the number of members, the LLC shareholders’ equivalent, is unlimited. Additionally, LLCs can be owned not only by US citizens and noncitizens alike but also by other business entities.

1. Division of Profits

One of the largest and potentially the most significant difference between an LLC and an S corp lies in their respective rules on the division of profits. In an S corporation, each shareholder is restricted to earning a percentage of profit that corresponds to the amount of capital they have contributed, or shares of stock they’ve purchased. (This is logical; if you hold a certain amount of stock in a company, the dividend checks you receive correspond to your stock ownership.)

The owners of an LLC, on the other hand, are free to adopt any type of profit distribution ratio they like, so long as all owners have agreed to it. This feature of LLCs is especially useful in situations where one owner has contributed most of the startup capital but does not have a great deal of responsibility as far as the day-to-day workings of the LLC, while the other party has contributed less capital but effectively runs the company.

2. LLC vs. S Corp—Employment Tax

LLC owners have options as far as tax structure, depending upon whether the LLC is single-owner or multiple-owner, but broadly, many LLCs must pay a self-employment tax, which is 15.3% (this goes toward Social Security, Medicare, and other purposes). The entire net income of an LLC is subject to this self-employment tax.

An S corporation’s income, by contrast, is not subject to this tax; as outlined above, the income is passed through to individual owners and is reported on their individual tax returns.

S Corporation Example

Adam owns an e-commerce company that brings in $60,000 in earnings per year. He pays himself a reasonable compensation of $35,000 to run the business, and he takes the remaining $25,000 as a distribution. Adam’s total employment tax is $5,355 (15.3% of the $35,000 only, his salary).

The temptation, of course, would be to take most of the money as a distribution, enabling you to avoid most of the employment tax. However, you cannot manipulate your salary to make it artificially low in order to pay less employment tax. If the salary isn’t a reasonable one for your industry and job type, the IRS could reclassify some of the distributions as salary or pierce the corporate veil.

LLC Example

Assume everything in the above example is the same, except that Adam’s entity is an LLC and not an S corporation. As an LLC, Adam would have to pay employment tax on the entire $60,000—not just his salary—which would equal $9,180.

Based on the two scenarios above, Adam would save $3,825 in employment tax as an S corporation.

3. A Few More Notes

The employment tax savings make the S corporation attractive; however, keep in mind that you still have to deal with paying payroll taxes, a pay-as-you-go tax that must be paid to the IRS regularly throughout the year (on time, or you will incur interest and penalties).

Unlike S corporations that pay as they go, owners of LLCs pay their self-employment tax once a year on April 15 when they would pay their personal income tax. A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor; partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.

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