S Corporation Restrictions
One advantage of an LLC over an S corporation is that S corporations are subject to a number of IRS restrictions. An S corporation may not have more than 100 shareholders and may not include corporations, partnerships or non-resident aliens among its shareholders. S corporations are also prohibited from engaging in certain industries such as insurance. If an S corporation violates any of these restrictions, such as adding its 101st shareholder, it loses its S corporation tax classification. None of these restrictions apply to LLCs.
An S corporation is subject to the same corporate formalities that apply to any other corporation. It must establish a board of directors, hold shareholders meetings, and keep minutes of all board and shareholders meetings. State law regulates corporate voting rights, operational procedures and share transfers. Although state law also restricts LLCs, regulation is far less restrictive for LLCs than for corporations. In some states, for example, an LLC owner, known as a member, may assign the economic benefits of his interest in the LLC to an outsider, yet keep his voting rights.
An LLC enjoys flexibility in its taxation options. In default, an LLC will be treated as a partnership by the IRS, or disregarded entirely if it has only one member. Under certain circumstances, however, it is possible for an LLC to lower its tax burden by choosing to be treated as a corporation for tax purposes. The IRS will allow an LLC to be taxed as either an S corporation or, if it does not qualify for S corporation tax treatment, as a C corporation. An LLC may change its tax treatment every few years, as business needs dictate.
The IRS assesses self-employment tax on self-employed persons in lieu of the Social Security and Medicare taxes that employers would otherwise deduct from their paychecks. Unless an LLC elects corporate tax treatment, LLC members are treated as self-employed by the IRS. They are subject to self-employment tax of up to 15.3 percent of their allocated share of LLC income, even if the LLC distributes no income to its members during the tax year. By contrast, S corporation shareholders are subject to Social Security and Medicare taxes only if they are also employees of the corporation and even then, only on income they receive as salary; dividends and undistributed corporate income are not subject to these taxes.