The S Corp designation is a popular choice for small business owners because of the tax advantages it offers. If you’re contemplating forming an LLC, electing to have your business taxed as an S Corp can put more money in your pocket.
Difference Between an LLC and S Corp
An LLC is a limited liability company formed under state law and is separate from its owners. LLC owners are called members and an LLC can have one, or multiple, members. LLCs are popular with sole or small business owners because they offer more management flexibility and fewer reporting and recordkeeping obligations than that of corporations.
In contrast to an LLC, an S Corp is not a legal business entity. Rather, it is a designation chosen by a business entity for tax purposes under the Internal Revenue Code.
Taxation of an S Corp
The most important difference between an LLC and an S Corp is in the way they are taxed. For tax purposes, the Internal Revenue Code classifies businesses as sole proprietorships, C Corporations, partnerships, or S Corporations. Thus, there is no LLC tax classification. Single-member LLCs are taxed as sole proprietorships and multi-member LLCs are taxed as partnerships. However, the Internal Revenue Code allows an LLC to elect to be taxed as a C Corporation or S Corporation.
For a single-member LLC that’s a sole proprietorship, the member (a) must report business income and expenses on their personal income tax return and pay tax on the LLC’s profits (i.e. income – expenses), and (b) because the Internal Revenue Code considers the member self-employed, the member must pay Social Security and Medicare taxes on those profits. Employees who aren’t self-employed must also pay these taxes, but the employee splits these taxes with their employer 50/50. For an LLC that elects to be an S Corp, though, the LLC owners will only pay Social Security and Medicare taxes on their salary (provided the IRS considers the salary reasonable) and not on all profits like the LLC owner who hasn’t elected S Corp status.
Here’s an example which illustrates this:
A sole proprietor LLC that hasn’t elected S Corp status makes $100,000 in profits. The owner of that LLC must report the $100,000 as income and pay Social Security and Medicare taxes on that entire $100,000.
If that same LLC earning $100,000 elects S Corp status and determines that the owner’s reasonable salary is $50,000, that salary will be considered a business expense. This leaves the LLC with a profit of $50,000 rather than $100,000. The $100,000 must still be reported as income, but the owner and the business will only pay Social Security and Medicare taxes on the $50,000 salary.
Exceptions to S Corp Classification
Not every business will qualify for taxation as an S Corp, including:
- A foreign LLC
- Where the LLC owner is a non-resident alien
- Where the LLC is set up so that the owner is actually a corporation or partnership
Choosing the Right Business Structure
Deciding how to legally structure your business can seem like an overwhelming task, but help is available. Attorney Steven Becker provides cost-effective legal support to small business owners and creatives. Contact Becker Law for assistance forming an LLC or S Corp.