S Corporation vs. LLC? LLC vs. S Corp? S Corp taxes? An LLC-S Corp? If you’re planning to start a limited liability company (LLC), you have heard some of these terms. You understand they have something to do with your company taxes, but what? Find out how to choose between an LLC or S corp for your business tax structure.
What Is an S Corporation?
An election to change the classification of your business from a limited liability company (LLC) to a subchapter S corporation (S corp) can have some pretty significant tax consequences. An S corporation:
- is a small, closely-held corporation
- chooses to be treated under subchapter S of the Internal Revenue Code
- is a domestic, eligible corporation
- has no more than 100 shareholders (and those shareholders can’t be partnerships, corporations or resident aliens)
- has only one class of stock
- can have strict formation guidelines
- must conduct any additional corporate formalities required under state law.
What Is a Limited Liability Company (LLC)?
A Limited Liability Company:
- is a business entity organized under state law
- does not have the legal status of a person
- does not issue stock
- has individual(s), or “member(s)” who are considered the owner(s)
- offers much more flexibility for who can be a member (in some states, an individual can structure their business entity as an LLC)
- has very few formal requirements (and usually less expensive to form).
Taxation: S Corp vs. LLC
In general terms both LLCs and S corps are subject to “pass-through” taxation. For S corps, income tax responsibility flows through the corporation to the shareholder and shows up as income on their taxes. For this reason, S corps aren't subject to corporate income tax. Instead, the shareholders report income and losses on their personal tax returns and are assessed at their individual income tax rates.
Take a corporate shareholder who works in the business. They would be considered by the IRS to be an employee. The IRS requires the corporation to pay a reasonable salary for the work the shareholder performs. Therefore, the shareholder is subject to individual taxes on their "wages" but wouldn't have to pay any self-employment taxes. Any remaining profits could be paid as dividends, which are taxed at a lower rate than wages.
As for LLC taxes, an LLC can be classified (for federal tax purposes) in four different ways in the U.S.: as a sole proprietorship (or single-member limited liability company, SMLLC), as a partnership, as a C corporation or as an S corporation. The owner of an SMLLC will be taxed, by default, as a sole proprietorship.
In the sole proprietorship classification of an LLC, income and deductions "pass through" to the owner of the company, much like the S corp model. However in direct contrast to the S corp, the SMLLC isn't considered an employee of the LLC and they would be subject to self-employment taxes. There is no federal income tax on the company itself and the activities of the LLC are reflected on its owner's federal tax return (Form 1040).
LLC Taxed as S Corp
Though an LLC isn't a corporation, it can elect to be classified as an S corp for tax purposes only. However, unless an LLC elects to be treated as an S corp, the LLC defaults to treatment as a sole proprietorship (or SMLLC). How else will it affect you? LLC tax filings are much more simplified when compared to those of S corp tax filings (a single member LLC can get away with filing a personal tax return). Compare that with an S corp (or S corp election) which means filing additional tax documents every year. If you are adverse to piles of paper, this is something else to consider.
Tip: S corp tax status must become effective within 75 days before filing or within 12 months after filing. Once an LLC elects a certain classification, it generally can't elect to change their classification again until 60 months after the effective date of election.
S Corp vs. LLC Tax Benefits
The main advantage of electing S corp classification for LLC owners is avoiding self-employment taxes.
Take for example, a sole proprietor of a new business. Drawn to the simple and less costly formation, he created his business as an LLC. The business has now become very active and the owner has seen sizable profits.
In the LLC model, no election would put him at sole proprietorship status. The owner would be required to pay self-employment taxes on any income generated under the LLC. Depending on the income, that can be a pretty high tax rate.
However, by electing to be treated as an S corp, the owner can pay himself a modest salary (which will be scrutinized by the IRS to see if it is reasonable) as an employee of the business, and treat the rest of the profits of his company as dividends, which will then be taxed at a lesser rate than his wages.
S Corp or LLC?
Tax treatment is usually one of the first considerations when forming a business entity. However, if you've already formed your business entity but are unhappy with the tax consequences headed your way, don't despair. You can elect, for example, to have your LLC be classified as an S corp. This may help legitimately avoid self-employment taxes.
Consider how you interact with your business. Are you the only employee? Are you working in your business every day or are you a silent owner? There is no simple answer to which tax classification you should pick, but an accountant or business attorney may be able to help you choose between an S corp versus LLC