The difference between an S-corp and LLC

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(FORTUNE Small Business) -- Dear FSB: My friends and I often dream up ideas for small businesses. One question we can never seem to answer is whether we should incorporate as an LLC or an S-corp. What are the real differences between these two incorporation types? Are there tax benefits we should be aware of, or common pitfalls?

-Michael Bassik, Washington, D.C.

Dear Michael: A limited liability company (LLC) and an S corporation (S-corp) are completely different things, says David Sokolow, a distinguished senior lecturer at the University of Texas School of Law.

"An S-Corp is a misnomer; it's not a form of business," he says.

Rather, it's a tax status. S-corp refers to Subchapter S of the IRS code, which says that if a corporation can meet all the requirements, it can be taxed in the same way as a partnership.

"Traditionally, a partnership form gave you pass-through taxation, i.e., the opportunity to not be taxed twice, which is what you wanted," Sokolow says. "Partnerships don't pay separate income tax, so they're only taxed once. Today, you can achieve the same sort of thing with an LLC."

Both LLCs and companies with S-corp status provide owners with limited liability protection. S-corp status "just says that if you jump through certain hoops, you'll be taxed the same way a partnership is," says Sokolow. There are restrictions: for example, you can't have more than 100 shareholders.

However, if you're an LLC, "there are no hoops to jump through," Sokolow says. "You can choose how you want to be taxed. You just say 'I want to be taxed as a partnership."

That way, you enjoy the tax benefits without all the regulations involved in S-corps. The biggest pitfall may be thinking you need S-corp status when, in fact, you can get all the benefits you're looking for from an LLC.

"S-Corp regulations are very detailed and very complicated," says Sokolow. "You don't want to deal with them if you don't have to. That's why the LLC is the form of choice today. Most people starting a small business are going to form an LLC."