Business owners who want to obtain personal liability protection but do not want the double taxation of a C corporation — where profits are first taxed at the corporate level and again when distributed to owners as dividends — have two entity choices: S corporation or limited liability company. Both of these choices offer the same personal liability protection and very similar tax treatment for profits and losses, which are taxed to owners and not to the entity. However, there are considerable differences. There is no right choice for all business owners; you must decide what structure will work better for your situation based on the following considerations.
S corporations were authorized by a 1958 law that eliminated the double taxation for a corporation without eliminating the personal liability protection for owners. Limited liability companies (LLCs) debuted in 1977 when Wyoming created the first LLC statute, and in 1988, the IRS said that LLCs could be taxed as partnerships despite the personal liability protection for owners. Why is this history important? From a tax perspective, the IRS has had many years to resolve S corporation issues while LLCs remain relatively new, with some matters still unresolved, as you'll see below.
In broad terms, both S corporations and LLCs are treated the same for federal income tax purposes, meaning that profits are taxed on owners' returns. However, there are some important differences. For example, losses passed through to an owner are deductible only to the extent of the owner's basis. For S corporations, this does not include any of the company's debt; for LLCs, the owner's basis can include his/her share of the company's debt (depending on the type of debt).
Also, S corporation owners can avoid paying estimated taxes to account for the tax on their share of profits by adjusting withholding on their salaries. LLC owners, who are not employees and don't receive salaries, must pay estimated taxes in most cases.
Social Security and Medicare taxes
Perhaps the biggest difference between S corporations and LLCs is how Social Security and Medicare taxes are figured for owners:
- S corporations. Because owners are employees, they and their corporations pay FICA taxes on their compensation. This compensation, which must be "reasonable," is likely less than corporate profits.
- LLCs. Owners are self-employed individuals who pay self-employment tax (essentially the employee and employer shares of FICA). Self-employment tax applies to any guaranteed payments to owners. The tax also applies to the owners' distributive shares (i.e., their share of profits) if the owners are member-managers. Thus, if they can control the daily operations of the business, they are treated like general partners for purposes of self-employment tax. The IRS has not issued any guidance on whether or to what extent non-member-managers owe self-employment tax on their distributive shares.
State tax treatment
Not all states view S corporations in the same way as the federal government for income tax purposes. For example, New Hampshire treats them as if they were C corporations. Some other states treat them as S corporations with tax profits up to a certain limit. For example, in New York, an S corporation pays a fixed minimum tax based on New York receipts.
Also, because S corporation owners have salaries and other taxable compensation, these are subject to state unemployment taxes and any disability taxes. Because LLC owners don't pay unemployment and disability taxes, they save the tax costs but can't receive benefits.
Any person or entity can be an owner in an LLC. S corporations, on the other hand, have many restrictions, including the number of shareholders (limited to 100) and the requirement that all owners be individuals who are U.S. citizens or residents (there are exceptions for certain trusts). In most states, if you want to be an S corporation, you need to make a separate election, in addition to the federal election.
For S corporations, there can be only one class of stock, and profits and losses must be allocated proportionately to the owners' interests. LLCs can, within limits, tailor owners' rights, obligations, and shares of profits and losses.
Administration and other matters
Raising capital may be easier with S corporations that can issue stock to investors. And equity crowdfunding may become available to S corporations; there is a bill pending in Congress (H.R.531) to waive the shareholder limit solely for this purpose. It's more complicated for LLCs to bring in investors.
S corporations may be a little more expensive to maintain. For example, under state law all corporations (including S corporations) must hold annual meetings; LLC requirements are usually dependent on their operating agreements and not on state law. There may be annual state filing fees for S corporations that don't apply to LLCs.
Tax preparation costs for a one-person company is less costly if it is organized as an LLC because only the completion of a Schedule C to accompany the owner's Form 1040 is necessary; no separate business tax return is required.
There are pros and cons for each entity choice. Also, keep in mind that an LLC can elect to be taxed for federal income tax purposes as an S corporation if this is desirable. The IRS has more information about S corporations and limited liability companies. Discuss with your tax and legal advisors which one works better for your business.