When researching the best legal structure for your small business, you may consider a limited liability company, or LLC, and an S corporation. Both LLCs and S corporations protect owners from personal liability for debts, and pass through their income to owners who then pay personal income taxes on those earnings. These entities have many similarities, and a few important differences, when it comes to taxation.
Both the LLC and the S corporation avoid corporate income taxes. The LLC is somewhat simpler in structure and in its burden of paperwork and regulation. Members of LLCs can decide how they will distribute income, while S corporations must distribute dividends according to the number of shares owned by their shareholders. LLC members may also deduct business losses on their personal income tax returns.
However, for federal tax purposes, LLC members are considered to be self-employed, and must pay self-employment income tax, which amounts to 15.3 percent of their net income after expenses and legal write-offs. This SE tax covers Social Security and Medicare payroll taxes, which would otherwise be paid 50/50 by an employee and an employer.
S Corporation Taxation
S corporation owners only pay the SE taxes on their salaries, not on their dividends or distributions from income. The IRS requires that a reasonable salary be paid, and will disqualify excessive distributions that are used in place of salary in order to escape the SE tax. As a result of this tax treatment, S corporations are also responsible for keeping track and paying one-half the payroll tax, which is shared with employees. This presents an additional bookkeeping task and a possible fine from the IRS if the payroll taxes are not submitted on time.
LLCs are normally classified as sole proprietorships or partnerships. But LLC members have the option of adopting the federal tax treatment of a C corporation or an S corporation. If they choose to use one of the latter classifications, they must file Form 2553 with the IRS and elect this option by March 15 of the tax year. The states have varying tax laws that, in some cases, force owners of S corporations to pay corporate income taxes as if the business operated as a C corporation. Consult an experienced business attorney in your state of operation for a full explanation of the tax law and treatment of LLCs and S corporations.