LLC Versus S Corporation Taxation

LLC Taxation

Like a sole proprietorship or a partnership, an LLC is not a separate tax entity from its owners; instead, it's what the IRS calls a "pass-through entity." This means the LLC itself does not pay any income taxes; instead, income passes through the business to each LLC owner, who pays taxes on the share of profit (or deducts the share of losses) on the owner's individual income tax return (for the feds, Form 1040 with Schedule E attached). But a multiowned LLC, like a partnership, does have to file Form 1065—an "informational return"—to let the government know how much the business earned or lost that year. No tax is paid with this return.

LLCs give members the flexibility to choose to have the company taxed like a corporation rather than as a pass-through entity. In fact, partnerships now have this option as well.

You may wonder why LLC owners would choose to be taxed as a corporation. After all, pass-through taxation is one of the most popular features of an LLC. The answer is that, because of the income-splitting strategy of corporations, LLC members can sometimes come out ahead by having their business taxed as a separate entity at corporate tax rates.

For example, if the owners of an LLC become successful enough to keep some profits in the business at the end of the year (or regularly need to keep significant profits in the business for upcoming expenses), paying tax at corporate tax rates can save them money. That's because federal income tax rates for corporations start at a lower rate than the rates for individuals. For this reason, many LLCs start out being taxed as partnerships, and when they make enough profit to justify keeping some in the business (rather than doling it out as salaries and bonuses), they opt for corporate-style taxation.

LLCs vs. S Corporations

Before LLCs came along, the only way all owners of a business could get limited personal liability was to form a corporation. Problem was, many entrepreneurs didn't want the hassle and expense of incorporating, not to mention the headache of dealing with corporate taxation. One easier option was to form a special type of corporation known as an S corporation, which is like a normal corporation in most respects, except that business profits pass through to the owner (as in a sole proprietorship or partnership), rather than being taxed to the corporation at corporate tax rates. In other words, S corporations offered the limited liability of a corporation with the pass-through taxation of a sole proprietorship or partnership. For a long time, this was an okay compromise for small-to-medium-sized businesses, though they still had to deal with requirements of running an S corporation.

Now, however, LLCs offer a better option. LLCs are indeed similar to S corporations in that they combine limited personal liability with pass-through tax status. But a significant difference between these two types of businesses is that LLCs are not bound by the many regulations that govern S corporations.

Here's a quick rundown of the major areas of difference between S corporations and LLCs.

• Ownership restrictions. An S corporation may not have more than 75 shareholders, all of whom must be U.S. citizens or residents. This means that some of the C corporation's main benefits—namely, the ability to set up stock option and bonus plans and to bring in public capital—are pretty much out of the question for S corporations. And even if an S corporation initially meets the U.S. citizen or resident requirement, its shareholders can't sell shares to another company (like a corporation or an LLC) or a foreign citizen, on pain of losing S corporation tax status. In an LLC, any type of person or entity can become a member—a U.S. citizen, a citizen of a foreign country, another LLC, a corporation, or a limited partnership.

• Allocation of profits and losses. Shareholders of an S corporation must allocate profits according to the percentage of stock each owner has. For example, a 25% owner has to receive 25% of the profits (or losses), even if the owners want a different division. Owners of an LLC, on the other hand, may distribute profits (and the tax burden that goes with them) however they see fit, without regard to each member's ownership share in the company. For instance, a member of an LLC who owns 25% of the business can receive 50% of the profits if the other members agree (subject to a few IRS rules).

• Corporate meeting and record-keeping rules. For S corporation shareholders to keep their limited liability protection, they have to follow the corporate rules: issuing stock, electing officers, holding regular board of directors' and shareholders' meetings, keeping corporate minutes of all meetings, and following the mandatory rules found in their state's corporation code. By contrast, LLC owners don't need to jump through most of these legal hoops—they just have to make sure their management team is in agreement on major decisions and go about their business.

• Tax treatment of losses. S corporation shareholders are at a disadvantage if their company goes into substantial debt—for instance, if it borrows money to open the business or buy real estate. That's because an S corporation's business debt cannot be passed along to its shareholders unless they have personally cosigned and guaranteed the debt. LLC owners, on the other hand, normally can reap the tax benefits of any business debt, cosigned or not. This can translate into a nice tax break for owners of LLCs that carry debt.

Excerpted from The Small Business Start-Up Kit, by Peri H. Pakroo (Nolo).