Learning the Differences Between S Corp vs LLC

Limited Liability Companies (LLC) and S Corporations have much in common.

Both S Corporations and LLCs are ‘pass-through’ entities for tax purposes and help avoid double taxation. Business owners of LLCs and S Corporations include profits from the business in their personal income tax returns. A standard corporation, on the other hand, pays corporate income tax on its gross profits, and the profit after tax that reaches the business owners still attracts business tax.

The double taxation avoidance offered by S Corporations and LLCs is available for Sole Proprietorships and Partnerships as well. S Corporations and LLCs, however, remain the preferred legal structures as they offer liability protection for the shareholders and secure their personal assets if the company runs up losses.

Image Credit: flickr.com/Wouter Kiel

Business Ownership and Operation

Comparing the S Corp vs LLC, the LLC offers operational ease and flexibility.

An S Corp is in the strict sense of term a tax status and not a legal structure. It refers to Subchapter S of the IRS code that allows taxation of the corporation in the same way as of a partnership if it meets all requirements.

Starting and running a Corporation entails elaborate record keeping and reporting formalities and constitution of a director board to manage the company operations.

The S Corporation needs to

• File an annual income tax return each year with IRS Form 1120S.
• File an annual report with the Secretary of State.
• Draft bylaws and minutes, and hold annual meetings.
• Issue stock and keep a paper trail of financial dealings between the corporation and its shareholders

To qualify as an S Corp, the corporation should have no more than 75 shareholders, with none of them nonresident aliens or other corporations or LLCs. An S Corp also needs to distribute profits strictly according to the ratio of stock ownership, with laws not allowing any other consideration such as efforts put in to determine the rate of disbursal of profits to the owners. S Corp laws instead require payment of “reasonable compensation” or wages separate from profits for the efforts put in by owners in the business.

A Limited Liability Company has very little ‘red tape’ and no restrictions on ownership or disbursal of profits. Any number of individuals or corporations can own the LLC, and the LLC can disburse profits in any manner it deems fit. The owners also have the freedom to operate the company without any restriction.

Employment Tax

Comparing the S Corporation versus LLC, the biggest advantage of the S Corporation is the ability to eliminate or minimize taxes.

The IRS considers owner(s) of LLCs as self-employed and as such required to pay annual ‘self-employment tax’ on the net-income of the business. This amount goes toward social security and Medicare. The rates for 2009 include 15.3 percent of the net income subject to a maximum of $106,800 as social security tax, and 2.9 percent of total income as Medicare tax.

For an S corporation, only the salary paid to the employee-owner attracts such employment tax, and the profits disbursed as dividends do not attract employment tax. S Corporations, however, attract payroll tax, a pay-as-you-go tax that requires much paperwork.

Which is Better?

When comparing an S Corp vs LLC, although S Corp offers some tax advantages, its detailed and complicated regulations offset much of the tax advantages, and make LLC the legal structure of choice for most small entrepreneurs.

Many entrepreneurs form an LLC and make a special election with the IRS on Form 2553 for taxation as an S Corp. This allows the business to enjoy the tax benefits of an S Corporation and retain the simplicity of an LLC.

The appropriate legal structure, however, depends on many factors such as the nature of the business, profit levels, number of employees, and other factors. A CPA or a specialized tax attorney can help shed detailed company specific insight as to the best structure.