The Internal Revenue Service allows both LLCs and S corporations to function as disregarded entities, meaning their corporate structure is disregarded for tax purposes. In other words, the corporate entity doesn't pay taxes. Instead, profits and losses pass through to the owners, who are taxed at the individual level. This means that profits are only taxed once, minimizing the overall amount of taxes paid in many circumstances. LLCs may also elect to be taxed at the corporate level.
S Corporations and Profit Sharing
The owners of an S corporation can only issue a single type of stock and must distribute profits to shareholders based on the percentage of stock owned by each. For example, if a shareholder owns 30 percent of stock in a company, he must receive 30 percent of the profits for tax purposes. Failure to keep this rule prompts the IRS to set aside the S corporation's favorable tax status.
LLCs and Profit Sharing
When an LLC elects to do business as a disregarded entity -- meaning it does not pay corporate taxes -- its members can divide profits as they see fit. For example, one member may own 75 percent of the business but agree to receive only 50 percent of the profits. Members who invest more time or money into the LLC can legally receive more of its profits, regardless of the percentage owned by the member.
When an owner of an LLC works for the LLC itself, he is considered self-employed and his compensation is deemed an equity distribution from the LLC. By contrast, when a shareholder works for an S corporation, he is considered an employee and his compensation is deemed a wage, just like any other employee. Thus, his compensation does not affect the proportion of profits he receives when it comes time for profit distribution.