Comparing LLCs to S-Corporations

our business is probably set up as a Limited Liability

YCompany (LLC), an S-Corporation or both. But what’s the difference, and under what circumstances would it make sense to change your LLC into an S-Corporation?

An LLC is a type of business entity (as compared to a sole proprietorship or corporation), while an S-Corporation is a tax election. An LLC is set up at the state level, while an S-Corporation election is made with the IRS at the federal level (and filed with your state’s secretary of state). Owners in an LLC are called “members,” while S-Corporation owners are called “shareholders.”

Both LLCs and S-Corporations protect your personal assets from business creditors, unlike a sole proprietorship. That means business losses are limited to the amount of your investment in the business. It’s important to keep your personal and business financial affairs completely separate to maintain the corporate veil and not run the risk of losing that protection for your personal financial situation.

by Stacy Smith

Taxation of Business Income

Business income in an LLC flows to the members to be taxed at their personal rate. Owners are responsible for paying their own self-employment taxes (both the employer and employee sides of FICA and Medicare, a total of 15.3% of income). Taxable business income is reported on Schedule C of each member’s personal tax return. The LLC members need to make quarterly estimated tax payments to keep up with anticipated tax liability throughout the year.

In contrast, S-Corporation shareholders take a salary, and like other employees, pay 7.65% in payroll taxes with the business paying the other half. The business can then take a tax deduction for the payroll tax expense. Any additional business profits are distributed to S-Corporation shareholders as dividends, which are not subject to payroll taxes. These dividends are allocated in proportion to each shareholder’s interest in the S-Corporation. S-Corporations file a separate tax return for the business using Form 1120-S.

It’s easier and generally less expensive to set up and maintain an LLC, which makes it a good choice for a smaller business just starting out. It also makes sense for a company with one or just a few owners who want maximum flexibility and control over the business.

An S-Corporation is governed by a board of directors and is required to maintain corporate minutes and hold annual shareholder meetings. More structure and regulatory requirements make S-Corporations more expensive than LLCs to both set up and maintain. Additional costs can include articles of incorporation, attorney fees, additional accounting fees for financial statements and tax preparation for the S-Corporation, state annual reporting fees and potentially additional state taxes depending on state laws. When establishing your S-Corporation, you first register as either an LLC or a C-Corporation and then elect S-Corporation status. Some states allow S-Corporations to be taxed as a pass-through entity (where income is taxed at the personal rather than corporate rate), but other states tax S-Corporations the same as C-Corporations. All owners in an S-Corporation must be U.S. citizens, and the number of owners is limited to 100, with spouses being considered as separate shareholders.

Be aware – in many states when a member joins or leaves an LLC, the state may require the LLC to be dissolved and re-formed with new members. In contrast, if any owners leave an S-Corporation, the corporation can continue with remaining owners.

Which One is Better?

Whether your business should be an LLC or makes an S-Corporation election depends on several considerations. If you’re just starting and your business is smaller, an LLC makes sense. As your LLC generates more income, your selfemployment taxes will also increase, making an S-Corporation more attractive. As mentioned above, S-Corporation shareholders can share in company profits through dividends without having to pay self-employment taxes.

However, S-Corporation shareholders must be paid “reasonable compensation” (compared to industry standards) for the services they perform for the business. It might be tempting to pay shareholders at a lower rate to compensate them through dividends and therefore avoid payroll taxes, but the IRS scrutinizes – and penalizes – such arrangements. Also, more-than-2% shareholders are not allowed to participate in tax-free employee benefits such as group health insurance or a cafeteria plan.

The additional oversight required of S-Corporations might also provide your business with more credibility, especially if you’re seeking outside investors or bank loans.

The Bottom Line

There’s not a one-size-fits-all answer to the appropriate entity for your organization. As your business grows and changes, today’s answer might not be the same in the future. It’s important to visit with your tax and/or legal advisors before making any changes to be sure you understand the ramifications and are in compliance with all applicable regulations. S

STACY SMITH, CPA, is a shareholder of Mize CPAs Inc. – a full-service accounting firm that has provided the Elevanta Accounting & Payroll solution since 2003.