Both LLCs and corporations are created under state law. To become an S corporation, however, a corporation must qualify under the Internal Revenue Code and file Form 8832 to claim S corporation status with the IRS. Significant differences exist in the taxation and operational flexibility of these two business vehicles.
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The Internal Revenue Corporation imposes a number of eligibility requirements on S corporations. An S corporation may have no more than 100 shareholders, and it may issue only one class of stock. It must be incorporated under the laws of a U.S. jurisdiction. Partnerships and corporations cannot be shareholders, and individual shareholders must be either U.S. citizens or legal residents of the United States. Most insurance companies and banks cannot become S corporations. LLCs are subject to only a few similar restrictions. For example, LLCs cannot issue shares, most banks and insurance companies cannot organize as LLCs, and special IRS tax rules apply to LLCs organized under the laws of a foreign jurisdiction.
S corporations, like other corporations, are required to observe certain formalities that many small businesses find cumbersome. A corporation must establish a board of directors, hold annual shareholders meetings, keep meeting minutes and pass formal resolutions. State law also regulates matters such as voting rights and quorums more strictly than LLCs. An LLC enjoys more flexible operating procedures; it need not establish a board of directors, nor does it have to keep meeting minutes. Some states even allow LLC owners to sell their rights to LLC profits to someone else while retaining full voting rights.
Both LLCs and S corporations are taxed as "pass-through" entities. This means that the entity itself is not subject to federal income taxes. Rather, taxable income is apportioned among the owners in proportion to their respective ownership interests; the income is taxed as the owners' income.
LLC owners and S corporation shareholders must pay self-employment tax on their apportioned shares of the company's net earnings. At the time of publication, self-employment tax was 13.3 percent of the first $106,800 in net earnings and 2.9 percent of any amount above that. However, S corporation shareholders can avoid self-employment tax if they are employed by the corporation and receive a salary. Although they must pay self-employment tax on their salaries, any amounts they receive beyond their salaries are considered dividends and are taxed at preferential tax rates. The IRS forbids S corporations from paying their owner-employees unrealistically low salaries to lower their tax burdens.