One of the more common questions I am asked by someone starting a business is, should I form an LLC or an S-Corp? This article will give a broad overview of a few tax differences between the two types of entities.
Differences in Tax Filings
I should note that an S-Corporation (S-Corp) does not start as an S-Corp, but is legally formed as a C Corporation. An example of a C Corporation would be Verizon, Walmart, or Apple. Small businesses can be C Corporations, but an owner of a small business corporation would most often make an “S-Election.” With a C Corporation, profits are taxed twice, once at the corporate level and then again when the corporation distributes the profit as a “dividend” to shareholders.
An “S-Election” can be made to help avoid double taxation, so the corporation’s profits are “passed through” to its shareholders and taxed on their personal tax returns, not at the corporate level.
There are certain instances where there could still be an entity-level tax at the federal or state level. Still, double taxation is generally avoided by making an S-Election.
The taxation of a Limited Liability Company (LLC) is different, depending on whether the LLC has one owner or multiple owners. Suppose there is one owner. In that case, the LLC is treated as being “disregarded” for tax purposes, which essentially means the activity from the LLC is reported directly on the owner’s personal tax return. Additional state filings could be required depending on the state(s) in which the owner lives & operates the business. Still, for federal purposes, the activity is reported on "Schedule C" of their personal tax return. An LLC that has multiple owners would file a “partnership” tax return. Each owner of the LLC would then receive a "Schedule K-1" from the partnership, reporting their share of income, deductions, and other tax items. The partner's share of items from the Schedule K-1 will "pass-through" and be reported on their personal tax return. Generally, there isn't a partnership-level tax. Instead, any profit would "pass-through" and be reported on a partner's personal tax return.
I should also note that it is also possible for an LLC to elect to be treated as an S-Corp for tax purposes. It’s beyond the scope of this article, but the ability for an LLC to make an S-Election is another consideration to take into account.
With both the S-Corporation and LLC, the income is taxed on the owner’s personal tax return and generally not at the LLC or S-Corporation level. However, there is a key difference in how that income may be taxed on the owner’s personal tax return. The income from an LLC may be subject to Self-Employment tax, while the pass-through income from an S-Corporation is not. For example, a law firm set up as an LLC could have $100,000 of profit, which would be subject to self-employment tax (unless the LLC made an S-Election). The $100,000 would not be subject to self-employment tax if that law firm was an S-Corp instead. Often this is one of the deciding factors for many small business owners when choosing an LLC or S-Corporation.
With the self-employment tax rate being at 15.3%, the tax difference can be significant. Of course, there are additional considerations to take into account that could mitigate some of the 15.3% tax savings by forming an S-Corp.
The IRS requires that S-Corporations pay shareholders that work within the business. This means that an S-Corporation will need to set up payroll for its shareholders that work in the business and pay them a “reasonable” wage.
The definition of “reasonable wage” can be subject to interpretation. Still, the general idea is that a shareholder should be paid a market-based salary. Essentially, a reasonable wage would equate to what you would pay someone for that same role the owner is performing.
Some advantages of being an S-Corporation to avoid self-employment tax are lost by requiring that a shareholder be paid a reasonable wage. The reason is that the S-Corporation would pay payroll taxes on the owner’s wages, and the owner would also pay Social Security and Medicare on those same wages.
Allocation of Profits & Losses
Generally, an LLC can be more flexible when allocating profit & losses and other tax items between multiple owners. An S-Corporation must allocate all items, such as income, deductions, tax credits, distributions, among its owners based upon the number of shares owned by each shareholder. For example, if there are two owners of an S-Corp and each owns 50 shares, then everything must be allocated 50/50 between the two owners. An LLC is more flexible in the way profits & losses and other tax items can be allocated. Owners do not necessarily get allocated profit following their ownership percentage. Depending on the “operating agreement” of an LLC, profit & losses and other items can be allocated however the owners choose based on their operating agreement (and subject to substantial economic effect rules of the IRS, which is beyond the scope of this article).
Real Estate Should Not Be Held in an S Corporation
I am not going to delve too far into this as the technical nature of the discussion would require its own separate article, but in almost all scenarios, real estate should not be held in an S Corporation. In nearly all cases, I would recommend an LLC for real estate.
Additional Compliance Costs Associated with an S Corporation
For businesses with one owner, there are additional compliance costs to consider when deciding between an LLC or an S-Corp. An S-Corporation is required to file a separate S-Corporation tax return and should set up payroll to pay its shareholder owner. A single-member LLC does not by default file a separate tax return. Instead, its activity is reported on the owner’s personal tax return. An LLC does not pay its owner with a w-2 (unless an LLC made the S-Election). So an S-Corporation could have additional costs associated with filing the S-Corporation tax return and hiring a payroll service to handle processing the payroll-related tax filings.
Types of Owners Limited for an S-Corporation
There are limitations on who can be a shareholder of an S-Corporation. Nonresident aliens are not allowed to be shareholders. Partnerships and C corporations also cannot be shareholders in an S Corporation. Certain trusts can qualify for S corporation status.
Which Should You Choose?
There are many factors to consider before forming a legal entity, more than this article can cover. There is no correct answer, and all variables should be considered, from the allocation of profits, to who can be an owner, to how the income will be taxed. Before forming an entity, I strongly recommend reaching out to a CPA or an attorney who can walk you through the differences and how they apply to your specific situation.