An LLC Versus an S Corp

by Joseph Nicholson
Both an S corp and an LLC allow their owners to report profits on individual tax returns.

Both an S corp and an LLC allow their owners to report profits on individual tax returns.

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Both an LCC and an S corp are business entity options for business owners looking for pass-through taxation. Because both types of business structures are disregarded by the IRS, their profit or loss is reported on the owners' individual tax returns. But while they share this similarity, there are crucial differences that should be considered before making any decisions.

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Organization

The LLC is a creation of state law, whereas an S corp exists relative to state law. Generally, an S corp is a business incorporated under state law and then classified as an S corp by the IRS by request of the owners. An LLC is not a corporation at all, and organization as an LLC precludes incorporation; however, the IRS treats an LLC as a corporation if the members elect to do so. An LLC that meets certain criteria can then also elect to be taxed as an S corp, but remains an LLC for all other purposes.

Self-Employment

A major difference between the tax treatment of an S corp and an LLC is that only the owners of the LLC are liable for self-employment tax. As of 2010, an LLC member who nets $400 or more from the business must complete Schedule SE and attach it to his individual 1040. This can be avoided by electing to be taxed as an S corp, the distributed profits of which are not subject to self-employment tax. Only regular wages or salaries paid by the S corp to the owner are subject to self-employment tax.

Formalities

Because an S corp is incorporated, it must conduct all the formalities required of corporations under the laws of the state of incorporation. This usually means filing annual reports, holding shareholders meetings and keeping minutes of those meetings. It also means the business must be structured like a corporation, with shareholders, executives and directors. There may also be state and federal laws on transferring ownership interests in the business. Conversely, LLCs have almost no limits on their structure and very few formal requirements. The LLC's Operating Agreement acts like a contract between the members, who are free to create almost any type of structure and division of ownership they desire.

Limited Liability

Both an S corp and an LLC provide their owners with limited protection from liability from the business's debts. This "veil" of limited liability only exists, however, as long as the business maintains independent records and does not mingle its finances with personal finances. With either type, using business accounts to pay personal expenses could result in being personally liable for the business's debts. Limited liability also does not apply in cases of fraud or outright illegal activity by LLC or S corp members.