There are restrictions on who can be owners (called “shareholders”) of an
S corporation. An S corporation can have no more than 75 shareholders. None
of the shareholders can be nonresident aliens. And shareholders cannot be
other corporations or LLCs.
An S corporationis operated in the same way as a traditional C corp. An S
corp. must follow the same formalities and record keeping procedures. The
directors or officers of an S corp. manage the company. And an S corp has no
flexibility in how profits are split up amongst its owners. The profits must
be distributed according to the ratio of stock ownership, even if the owners
may otherwise feel it is more equitable to distribute the profits
differently.
LLCs offer greater flexibility in ownership and ease of operation. There
are no restrictions on the ownership of an LLC. An LLC is simpler to operate
because it is not subject to the formalities by which S corps must abide. An
LLC can be member-managed, meaning that the owners run the company; or it
can be manager-managed, with responsibility delegated to managers who may or
may not be owners in the LLC.
And the owners of an LLC can distribute profits in the manner they see
fit.
Let’s say, for example, you and a partner own an LLC. Your partner
contributed $40,000 for capital. You only contributed $10,000 but you
perform 90% of the work. The two of you decide that, in the interest of
fairness, you will each share the profits 50/50. As an LLC you could do
that; with an S corporation, however, you could only take 20% of the profits
while your partner would take the other 80%.
A major factor that differentiates an S corporation from an LLC is the
employment tax that is paid on earnings. The owner of an LLC is considered
to be self-employed and, as such, must pay a “self-employment tax” of 15.3%
which goes toward social security and Medicare. The entire net income of the
business is subject to self-employment tax.*
In an S corporation, only the salary paid to the employee-owner is
subject to employment tax. The remaining income that is paid as a
distribution is not subject to employment tax under IRS rules. Therefore,
there is the potential to realize substantial employment tax savings. Case
in point:
Mary owns a print shop. In keeping with the industry standard, Mary
decides that a reasonable salary for a print shop manager is $35,000 and
pays herself accordingly. Mary’s total earnings for the year are $60,000:
$35,000 paid in salary and the remaining $25,000 paid as a distribution from
the S corp. Mary’s total employment tax is $5,355 (15.3% of $35,000).
If Mary were the owner of an LLC, she would have to pay employment tax on
the entire $60,000, equaling $9,180. But as an S corporation, she realizes
savings of $3,825 in employment tax.
One might assume that these savings could be further manipulated by
reducing the salary to an extremely low amount and attributing the rest of
one’s earnings to distributions—but this would be an incorrect assumption.
In practice, the IRS is careful to notice whether a salary is reasonable by
industry standards. If it determines a salary to be unreasonable, the IRS
will not hesitate to reclassify distributions as salary.
Still, while the potential employment tax savings may make the S
corporation an attractive structure for your business, bear in mind that you
would then have to deal with all the paperwork associated with payroll tax.
The payroll tax is a pay-as-you-go tax that must be paid to the IRS
regularly throughout the year--on time, or you will incur interest and
penalties. The paperwork alone can be an overwhelming task for someone who
is not familiar with this; and if you expect to incur losses or otherwise
experience a cash flow crunch during the year that would hinder you from
paying the payroll tax when due, this could present a problem.
Owners of LLCs pay their self-employment tax once a year on April 15 when
income taxes are normally due. Income tax filings are also relatively easy
for the owners of an LLC: A single-member LLC files the same 1040 tax return
and Schedule C as a sole proprietor; partners in an LLC file the same 1065
partnership tax return as do owners of traditional partnerships.
The comparison chart below sums up the similarities and differences
between the two business structures:
| |
S Corporation
|
Limited Liability Company
|
|
Liability Protection |
Yes
|
Yes
|
|
Operational Control |
Board of Directors/Officers |
May be member-managed or manager-managed
|
|
Federal Income Tax |
Pass-through
|
Pass-through
|
|
Flexibility/Ease of Operation |
No; subject to some formalities and record keeping rules as
traditional C corps |
Yes
|
|
Ownership Restrictions |
Yes
|
No
|
|
Flexibility in Profit-Sharing |
No
|
Yes |
|
Employment Tax |
Employment/payroll tax on salary; no employment tax on dividends
paid to shareholders
|
Self-employment tax on total net income
* |
There is no one, magical entity that works for everyone. A CPA or a
specialized tax attorney can assist you in choosing the right structure for
your business. The important thing is to consider the operational, legal and
tax aspects of each structure as they apply to your unique situation.
* The self-employment tax rate for 2009 consists of two parts: 15.3% for social
security and 2.9% for Medicare. In 2009, only the first $106,800 of total net
income is subject to the social security portion of the tax. All of the the
total net income is subject to the Medicare portion of the tax.
An LLC that is taxed as an S corp is still a limited liability company
from a legal standpoint (subject to the laws governing limited liability
companies in the state of formation); however, for tax purposes it is
treated as an S corp.
A word of caution: Certain nuances of S corp taxation can be
confusing to some LLC owners, especially do-it-yourselfers and/or those who
prepare their own tax returns; for example, an LLC owner might easily make
the mistake of referring to an IRS publication that addresses LLCs when, in
fact, such a publication would not apply to an LLC that is taxed as an S
corp--and such an error could lead to negative tax consequences. It is
therefore highly recommended that you consult a CPA or other qualified tax
professional for advice and/or assistance.
About the Author:
Chrissie Mould has over a decade of experience in corporate and small
business administration and startup business consulting. She is an
incorporation specialist and CEO of New Ventures, LLC. The company provides
low-cost incorporation services to entrepreneurs and small businesses.
Updated April 2009
