An S corporation isn’t a type of business structure — it’s a tax designation applied to different types of business entities. LLCs, C corporations, and partnerships all can incur taxes as an S corporation.
An LLC operating as a sole proprietorship or partnership differs in several ways from one that has elected to be taxed as an S Corp. Understanding these differences is crucial when deciding whether or not an S Corp designation is a good fit for your company.
Few restrictions exist for LLC ownership. Generally, there’s no maximum number of members permitted in an LLC, and other companies and foreign nationals may own LLCs. In contrast, S corporations may have a maximum of 100 owners and each owner must be a U.S. citizen or permanent legal resident. Owners of S corporations also may not include LLCs, other corporations, or certain types of trusts.
S corporations must comply with many more requirements related to business operations than LLCs. For example, they must issue stock, elect directors, hold regular director and shareholder meetings, and keep minutes of those meetings. Along with these obligations comes additional paperwork and increased expense. LLCs, on the other hand, don’t have to elect directors who then appoint management. They also don’t need to hold regular member meetings, although it’s recommended. Some states require LLCs to file an annual or biennial report, but, beyond that, LLCs face very little formal paperwork related to their business operations.
LLCs also have more flexibility in how they distribute their profits. S corporations must allocate profits based on the percentage of the company that each shareholder owns. In an LLC, the company’s operating agreement stipulates the percentage of profits allocated to each LLC member. Those allocations might not align with the percentage of the company that the member owns or of their initial capital investment.
Government Recognition and Taxes
While S corporations have their own classification under Internal Revenue Service regulations, the federal government does not recognize LLCs as taxable business entities. Instead, by default, the federal government taxes single-member LLCs as sole proprietorships and multi-member LLCs as partnerships. However, LLCs have the flexibility to instead choose the same method of taxation as a C corporation or an S corporation.
Sole proprietorships, partnerships, and S corporations all have pass-through tax structures. This means the company does not have to pay income tax on its profits because those profits instead pass through to the business owners’ individual tax returns.
So what are the key differences between default sole proprietorship or partnership taxes and S corporation taxes? Most importantly, S corporation owners don’t pay self-employment taxes (i.e., Social Security and Medicare) because the government considers them employees of the company. This means the company only pays these taxes on the amount of the owner’s salary instead of the owner paying them on the total amount of the company’s profits.
In addition, an S corporation may invite closer scrutiny from the IRS because it uses a more complex tax designation than a sole proprietorship or partnership. This complexity also can lead to more accounting or filing mistakes, which could result in the IRS stripping a business of its S corporation status.
LLCs Taxed as S Corporations
After weighing the pros and cons, you may decide taxing your LLC as an S corporation is the right choice for your business. If so, you’ll likely benefit from the relatively minimal reporting and administrative requirements of an LLC combined with the potential tax advantages of an S corporation.
You should experience a smooth reclassification process as long as your company limits its shareholders to 100 or fewer — and none of them are non-resident aliens or other companies. If your business meets these qualifications, you just need to file a Form 2553 with the IRS before March 15 to reclassify your LLC as an S corporation for the current tax year.