What is an LLC and S Corporation?
An LLC is a business entity that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. LLC owners report their business profits and losses on their personal income tax returns; the LLC itself is not itself taxed. For example, for a single-member LLC, the owner would LLC income or loss on his or her Schedule C as part of his or her tax return. Like corporations, LLC owners are protected from personal liability for business debts and claims. Thus, if the LLC is sued or owes money to a third party, generally only the assets of the business itself are at risk. This business form, thus, offers flexibility for the owner and is well-suited for companies with a single owner.
An S corporation is a closely held corporation that make the election to be taxed under Subchapter S of the Internal Revenue Code. Like LLCs, the S corporation does not itself pay taxes. Instead, income and losses are passed to its shareholders, who then report the income or loss on their personal tax returns. S corporations also offer the protection of limited liability for its owner(s) and shareholders. In order to qualify as an S corporation, several criteria must be met: it must be a domestic corporation, elect to be taxed as an S corporation, have only one class of stock, have less than 100 shareholders, and the shareholders must be U.S. citizens or residents. If the corporation meets these requirements, the shareholders can sign and file Form 2553 with the IRS and be taxed under Subchapter S.
LLC v. S Corporation
Both LLC’s and S corporations offer limited liability protection. Thus, owners of these entities are not personally responsible for business debts and liabilities. Additionally, both are pass-through entities. Business profits and losses are passed-through to the owners, who report these items on their personal income tax returns. Finally, both are separate legal entities created by a state filing.
LLCs and S corporations primarily differ in ownership, management, required formalities and taxation. As to ownership, LLCs can have an unlimited number of members, while S corporations can have a maximum of 100 owners (shareholders). Also, S corporations cannot have individuals who are not U.S. citizens or residents be shareholders, while LLCs can have non-U.S. citizens or residents be members. Finally, LLCs can have subsidiaries without any restrictions, while S corporations must meet certain requirements to have a Qualified Subchapter S Subsidiary (QSSS).
The management of an S corporation is also much more burdensome than for an LLC. Owners of an LLC can choose to have members (owners) run the LLC or can elect to have manages oversee the LLC’s operations. However, for an S corporation, directors and officers must be appointed. The board of directors oversee corporate affairs and vote on officers who will manage the day-to-day operations of the business.
The formalities for an S corporation are much more extensive than for an LLC. While it is advisable for an LLC to have an operating agreement in place (particularly for multi-member LLCs), there is no state requirement. In essence, LLCs can be managed as the owner(s) sees fit. However, S corporations have to meet certain statutory requirements, which are quite extensive. S corporations must adopt bylaws, issue stock, hold initial and annual director and shareholder meetings, and keep meeting minutes with the corporate records.
Taxation of an LLC is quite simple, but also offers several options, while S corporation taxation is quite strict, but offers some benefits over an LLC. LLCs are taxed as a partnership or sole proprietorship by default, but can elect to be taxed as an S or C corporation. LLCs are not required to pay members a salary, and all profits and losses are reported on the owner(s) personal tax returns. The drawback, however, to LLC taxation (as opposed to electing corporate taxation) is that LLCs must pay self-employment tax on all revenue. S corporations, however, must pay shareholders who provide services to the business (i.e., employed by the S corporation) a “reasonable” salary before profits can be distributed to the shareholders. This “reasonable” salary is subject to self-employment taxes, but once the “reasonable” salary is paid, all business profits that are distributed to shareholders are not subject to self-employment taxes.
LLC Formation, S Corporation Taxation
A prospective business owner can form as an LLC, but then elect to be treated as an S corporation by the IRS for tax purposes. This election can be made by filing Form 2553 with the IRS. This does not affect the legal standing of the LLC. You will still have the ease of administration of being an LLC. However, from a tax perspective, your LLC will be treated as an S corporation and gain certain tax benefits only available to S corporations.
In contrast to an LLC, where the owner is not an employee of the business, the owner(s) of an S corporation wears two hats: shareholder (owner) and employee. As an employee, the shareholder must be paid a “reasonable” salary and report those earnings on his or her personal income tax return. Those earnings are taxed as any employee’s would be (i.e., the corporation must withhold taxes). Being classified as an S corporation for taxation purposes has one enormous advantage over LLCs: S corporation taxation can allow the owner(s) to take some money out of the business without paying employment taxes. This money to be taken out is called a distribution. Distributions of profit from the S corporation (i.e., profits that pass-through the corporation to individuals as owners, not as employees) are not subject to employment taxes.
Let’s look at an example. David forms an LLC to operate his business and elects to have it taxed as an S corporation. David is an employee of the LLC and receives a “reasonable” salary of $60k. There is a remaining business profit of $60k that is passed-through the S corporation to David and is reported as a distribution on David’s personal income tax return. Since this is not an employee salary, neither David nor the LLC needs to pay Social Security or Medicare tax on this distribution. David and his LLC would only pay $9,180 in employment taxes (15.3% x $60,000). If David did not elect S corporation taxation for his LLC, David would have had to pay self-employment tax on his entire $120,000 profit.
This article should not be taken as legal advice and does not create an attorney-client relationship. For a detailed discussion on taxation, please contact a tax professional. If you wish to form an LLC, call (614) 987-0192 and speak attorney David Johnson at Johnson Legal, LLC.