As mentioned above, an S corporation isn’t a type of business structure — it’s a pass-through tax designation applied to different types of business entities. An LLC and a C corporation can choose to be taxed as an S corporation, provided they meet certain criteria.
S corp owners can save money on employment taxes by distributing their earnings to members and passive shareholders. Owners of an S corp that play an active role must become employees and be paid a “reasonable salary" (earned income) based on their position and industry. This earned income is subject to both personal income tax and employment tax, while the remaining business profits are only subject to personal income tax.
An LLC operating as a disregarded entity 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.
Ownership and Business Operation Requirements
Few restrictions exist for LLC ownership and business operations. Generally, there’s no maximum number of members permitted in an LLC. In addition, other companies and foreign nationals may own LLCs.
In contrast, S corporations must comply with more requirements, such as the following:
- They must not have more than 100 shareholders.
- Shareholders must be U.S. citizens or permanent legal residents.
- All shareholders must be private individuals, and may not include LLCs, other corporations, or certain types of trusts.
- The business can only issue one class of stock.
Although not required by law, it may be helpful for LLCs with S corporation status to conduct shareholder meetings and record minutes in case of a lawsuit or other legal matter. Along with these obligations come additional paperwork and increased expenses. In contrast, some states require LLCs to file an annual or biennial report, but beyond that, these LLCs face very little formal paperwork related to their business operations.
LLCs also have more flexibility in how they distribute their profits (revenue minus expenses). S corporations must allocate profits based on designated member salaries and for shareholders, the percentage of the company that each owns. In an LLC, the company’s Operating Agreement specifies 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 (IRS) regulations, the federal government does not recognize LLCs as taxable business entities. Instead, by default, the federal government taxes single-member LLCs as disregarded entities 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.
Disregarded entities, partnerships, and S corporations are all pass-through tax structures. This means the company does not have to pay income tax or employment 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 disregarded entity or partnership taxes and S corporation taxes? Most importantly, S corporation owners pay income tax and employment taxes (i.e., Social Security and Medicare), but employment tax is only paid on the members'/owners' salaries because the government considers them employees of the company. This means the company’s remaining distributions — what is left after expenses, including salary — are only subject to income tax instead of both income and employment taxes.
After both employment and income taxes are paid on salary to its members and distributions to shareholders, the remaining balance is known as “retained earnings.”
- Company profits (meaning after expenses, salary, and distributions are accounted for): only income tax
- Member salaries: employment tax and income tax
In addition, an S corporation may invite closer scrutiny from the IRS because it uses a more complex tax designation than a disregarded entity 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.
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.
- If you have already elected S-Corp status, be careful when electing a new tax status for your LLC, since the IRS will only allow you to designate S-Corp status once again after five years.