S Corp vs. LLC
Budding businesses have several options on what type of enterprise they would like to set out to be. This article discusses two of these, LLCs and S Corporations, and lays out the similarities and differences between the two types.
Similarities between LLCs and S Corporations
An LLC (limited liability company) is a type of business enterprise that is a legal form of a business company. It is a legal entity created by state law, through the filing of articles. Like the name suggests, it provides limited liability to its owners. LLCs have certain elements of both corporations and partnerships. It is not, however, a corporation, but instead is a type of unincorporated association. LLC owners enjoy a great amount of flexibility in determining how their enterprise will be governed, as long as they are consistent with the mandates, typically provided by state statutes. Generally, LLCs are treated as entities separate from their members. A one-member LLC can choose to be treated as either.
An S Corporation is one that makes a valid election to be taxed under Subchapter S of Chapter 1, of the Internal Revenue Code. As a result, S Corporations are technically tax accounting classifications and are not legal entities. They do not pay federal taxes, but their income and losses are divided among their shareholders, who report the income/loss on their own individual tax returns. An S Corporation is usually subject to the law of the state in which it was formed. They are separate legal entities from their shareholders, who enjoy the same liability protection as standard C Corporation shareholders. S Corporations are not eligible for dividend received deductions, and they are also not subject to the 10% of taxable income limitation on charitable contribution deductions.
Both LLC and S Corporations are “pass-through” entities for tax purposes, in that the companies’ income is passed through to their owners, and reported on the owners’ personal income tax returns. This removes the double taxation experienced by standard corporation owners. Also, both types of corporations offer liability protection to the owners. There are a number of differences between the two entities, however.
Differences between LLCs and S Corporations: Shareholders and Employment Tax
S Corporations have limits on the number of shareholders and can have no more than 75. These shareholders may not be nonresident aliens, nor may they be shareholders for other corporations or for LLCs. S Corporations must also follow the same operational rules as standard C corporations, where the directors or officers of the corporation manage the company. Profits in an S corporation must also be split according to the ratio of stock ownership, even if this turns out not to be the most equitable method of distribution of profits.
LLCs, on the other hand, are more flexible in regards to ownership and ease of operation, as there are no restrictions as to owners or shareholders of an LLC. They can either be member-managed (by the owners) or manager-managed (by delegated managers who may or may not be owners). Additionally, LLCs can distribute their profits however they would like, without restrictions.
Another crucial difference between the two types of corporations is the employment tax paid on earnings. An LLC owner is considered self-employed and must pay a “self-employment tax” of 15.3% towards Social Security and Medicare. Also, the corporation’s entire net income is subject to this tax.
With S Corporations, on the other hand, the only income subject to this employment tax is the salary paid to the employee-owner. Any remaining income paid as a distribution to the employee-owner is not subject to this tax, so employee-owners can realize a large amount of potential tax savings. While this aspect may seemingly make S Corporations very attractive, there is associated payroll tax that involves more paperwork, because it must be paid to the IRS around the year. If a payment is missed or late, interest and penalties will be incurred. LLC owners only pay self-employment tax once a year on April 15, and single-owners file the same 1040 tax return and Schedule C as sole proprietors; partner-owners file the traditional 1065 partnership tax return. However, in California LLCs are subject to “franchise taxes” levied by the state, in addition to typical income tax. One-member LLCs can also be “ignored” for tax purposes, in that the sole member can report the LLC’s activities on his or her own individual tax return. An LLC with multiple partners can elect to be treated as a partnership for tax purposes, or as a C or S corporation. If treated as a partnership, the LLC will have more opportunities to save taxes, but also more complicated tax accounting than LLCs treated as S Corporations.
Differences between LLCs and S Corporations (continued): Filing Requirements and Restrictions
In regards to California filing requirements, both LLCs and S Corporations complete Form 100-ES to report their estimated taxes, and both have the option to pay estimated tax in four installments throughout the year. Any LLC that is organized, registered, conducts business in, or receives source income from California must file California Form 100. This form must be filed by the 15th day of the 3rd month after the LLC’s taxable year closes. Partnerships or disregarded entities must also file California Form 568 LLC Return of Income, and also pay an annual tax of $800. Furthermore, any 568 with members who are non-California residents must file another form FTB 3832, LLC Nonresident Members’ Consent, along with their 568. LLCs are taxed at the corporate rate of 8.84% in California, and are subject to the minimum tax of $800.
S corporations that organize, register, conduct business in or receive source income from California must file California Form 100S, California S Corporation Franchise or Income Tax Return. Additionally, S Corporations must provide all shareholders with a Schedule K-1, stating what the shareholder’s pro rata share of the S Corporation’s items of income, deductions and credits. S Corporations are taxed on their net income at a rate of 1.5% for California purposes, and are not subject to income tax for federal income tax purposes.
There are some restrictions on who can or cannot incorporate as an LLC or S Corporation. Businesses in the banking, trust, and insurance industry are prohibited from forming LLCs. In addition, California prohibits professionals such as architects, accountants, doctors, and licensed healthcare workers from forming LLCs. California also excludes these professionals from operating as S Corporations, but there are fewer limitations on other businesses. To operate as an S Corporation, the business must be a domestic U.S. corporation, must have a limited number of shareholders, must be U.S. citizens or permanent residents, and must only have one class of stock.
(This article is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. If you have any questions about this Article, please call or e-mail Stephen Vokshori, Esq. (213.785.5366 / firstname.lastname@example.org) or any other member of Vokshori Law Group.)