You hit the nail right on the head. An LLC that elects to be taxed as an S corp possesses an interesting duality.
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From a legal standpoint, it is a business entity that is governed by the laws governing limited liability companies in the state of formation. It offers liability protection to its owners (members of LLCs typically are not responsible for the debts and financial obligations of the company) in the way that a corporation offers limited liability protection to its shareholders. But, unlike a corporation, LLCs tend to be easier to manage because they are generally not subject to corporate formalities and recordkeeping requirements such as annual shareholder meetings, board resolutions and meeting minutes, etc.

From a tax standpoint, an LLC that is taxed as an S corp is no different than a straight S corp (i.e., a corporation that elects to be taxed as an S corp). In addition to being a shareholder, the owner-officer of an S corp who performs services on behalf of the S corp is considered to be an employee of the S corp. Therefore, there are two primary ways in which an owner-officer of an S corp would take funds out of the S corp: 1) Via a shareholder distribution (of profit) and 2) via a salary for his or her work as an employee of the S corp. In an S corp, only salaries paid to employees are subject to employment taxes; shareholder distributions are not subject to employment taxes. The same would apply to the owner-employee of an LLC that is taxed as an S corp.

This is in stark contrast to an LLC that does not make an election to be taxed as an S corp. By default, a single-member LLC (an LLC with only one owner) is a disregarded entity for tax purposes and treated by the IRS (Internal Revenue Service) as a sole proprietorship. Just like any other sole proprietor, the owner of this type of LLC is considered to be "self-employed" and, in addition to income tax, must pay a a self-employment tax equal to 15.3% on net earnings from self-employment. The self-employment tax is made up of two parts: Social security tax (in 2007, on up to $94,200 of net earnings) and Medicare tax (on all net earnings of at least $400).

The self-employed owner of an LLC does not take a salary for his or her services. He or she can take an "owner's draw", or withdrawal of capital, if desired. But the total net income would still be subject to self-employment tax as previously explained (as well as income tax), whether the owner takes an owner's draw or not.

Some tax professionals discourage the use of LLCs taxed as S corps and advocate the formation of straight S corporations instead, arguing that the former can be a source of confusion for business owners who attempt to prepare their tax returns themselves. Often self-preparers look to IRS publications for assistance in preparing their tax returns, and in so doing, may inadvertently apply the rules regarding traditional LLCs when, in fact, S corp rules apply.

Also, a business owner may not know that certain transactions that would not otherwise be taxable events with a traditional LLC (e.g. the transfer of assets between the company and its owner) could have tax implications with an LLC that is taxed as an S corp. Still, for the solo entrepreneur or small business owner seeking management ease along with the tax benefits of an S corp, forming an LLC that is taxed as an S corp can be an attractive option. If you do decide to form an LLC that is taxed as an S corp, I would recommend that you consider using the services of a qualified CPA to prepare your tax returns so as to avoid any possible confusion.

Chrissie Mould