The main similarity between Limited Liability Company (LLC) and Subchapter S Corporation (S Corp) entity types is that they both allow the benefits of limited liability protection and pass-through taxation. However, both these entity types have their unique set of advantages and disadvantages that you should be aware of, while deciding which one of the two types is more beneficial for your unique circumstances.
An LLC offers ease of creation, less restrictions on ownership structure, and fewer reporting requirements and corporate formalities. An LLC allows profits and losses to be shared among its members in a manner other than member’s pro-rata ownership in business. Also, a single-member LLC is permitted to report business activities on owner’s personal income tax return rather than filing a separate tax return. A couple of potential downsides of an LLC in comparison to an S Corporation is that you may potentially pay more in employment taxes, and there are some restrictions regarding whom you can sell your business ownership interests to.
An S corporation has restrictions as to who can be an owner and the number of owners there can be. An S corporation requires its profits and losses to be shared in proportion to each shareholder’s ownership in business. In addition, an S Corporation is always required to file a tax return, regardless of income or loss. Shareholders of an S Corporation are required to pay estimated taxes on their income from S Corporation on their own returns. A couple of potential benefits of an S Corporation in comparison to an LLC is that you may potentially pay less in employment taxes, and there are generally no restrictions regarding whom you can sell your business ownership interests to.
The biggest consideration in deciding between an LLC and an S corporation is employment taxes.
An LLC owner is considered self-employed and not required to withdraw a salary. An S corporation shareholder, on the other hand, is not considered self-employed, and is required to withdraw a reasonable salary for his/her time and efforts devoted to the business. In essence, an LLC owner pays self-employment taxes on all profits distributed to him/her, whereas, an S corporation shareholder pays self-employment taxes only on the reasonable salary he/she is required to withdraw. S corporation profits, net of the reasonable salaries paid to the shareholders, are not subject to self-employment taxes.
IRS does not provide specific guidelines as to what is considered as reasonable salary. It is the responsibility of taxpayer to determine that. Factors considered by the courts in determining reasonable salary for employees or officers of an S corporation include duties and responsibilities, training and experience, time and efforts devoted to the business, dividend history, amounts that comparable businesses pay for similar services, etc.
In the end, there is no single right answer to the question as to which one is better – LLC or S corporation. The answer depends on your unique circumstances. Consult your CPA to weigh pros and cons of each entity type and select the one that is best for your situation.