S Corp vs. LLC

Which Structure is Right for Your Business?

Determining the type of legal structure for a new business can be daunting for entrepreneurs and owners. Learn more about S Corporations and Limited Liability Companies (LLC), and decide if one of these business structures is right for you.

Determining the type of legal structure for a new business can be daunting for entrepreneurs and small business owners. Corporations and limited liability companies (“LLCs”) are preferred business structures because, unlike sole proprietorships and partnerships, both offer liability protection. This means that the owner of a company cannot be held personally responsible for the company’s debts. The personal assets of an owner are shielded from company liabilities.  

In researching the various business structures, one inevitably comes across the S corporation. S corps and LLCs are similar in that they are both “pass-through” entities for tax purposes; the income of these companies are passed through to their owners and reported on the owners’ personal income tax returns, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation. (With a C corporation, the net business income is subject to corporate income tax, and the monies remaining after the corporate income tax are taxed a second time when they are distributed as dividends to its owners who must then pay personal income tax.)

So what is the difference between an S corporation and an LLC? And which structure is right for you?

The answer depends on your own unique situation. If operational ease and flexibility are important to you, an LLC is a good choice. If you are looking to save on employment tax and your situation warrants it, an S corporation could work for you.

Business Ownership & Operation

There are restrictions on who can be owners (called “shareholders”) of an S corporation. An S corporation can have no more than 75 shareholders. None of the shareholders can be nonresident aliens. And shareholders cannot be other corporations or LLCs.

An S corporationis operated in the same way as a traditional C corp. An S corp. must follow the same formalities and record keeping procedures. The directors or officers of an S corp. manage the company. And an S corp has no flexibility in how profits are split up amongst its owners. The profits must be distributed according to the ratio of stock ownership, even if the owners may otherwise feel it is more equitable to distribute the profits differently.

LLCs offer greater flexibility in ownership and ease of operation. There are no restrictions on the ownership of an LLC. An LLC is simpler to operate because it is not subject to the formalities by which S corps must abide. An LLC can be member-managed, meaning that the owners run the company; or it can be manager-managed, with responsibility delegated to managers who may or may not be owners in the LLC.

And the owners of an LLC can distribute profits in the manner they see fit.

Let’s say, for example, you and a partner own an LLC. Your partner contributed $40,000 for capital. You only contributed $10,000 but you perform 90% of the work. The two of you decide that, in the interest of fairness, you will each share the profits 50/50. As an LLC you could do that; with an S corporation, however, you could only take 20% of the profits while your partner would take the other 80%.

Employment Tax: Savings vs. Paperwork

A major factor that differentiates an S corporation from an LLC is the employment tax that is paid on earnings. The owner of an LLC is considered to be self-employed and, as such, must pay a “self-employment tax” of 15.3% which goes toward social security and Medicare. The entire net income of the business is subject to self-employment tax.*

In an S corporation, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules. Therefore, there is the potential to realize substantial employment tax savings. Case in point:

Mary owns a print shop. In keeping with the industry standard, Mary decides that a reasonable salary for a print shop manager is $35,000 and pays herself accordingly. Mary’s total earnings for the year are $60,000: $35,000 paid in salary and the remaining $25,000 paid as a distribution from the S corp. Mary’s total employment tax is $5,355 (15.3% of $35,000).

If Mary were the owner of an LLC, she would have to pay employment tax on the entire $60,000, equaling $9,180. But as an S corporation, she realizes savings of $3,825 in employment tax.

One might assume that these savings could be further manipulated by reducing the salary to an extremely low amount and attributing the rest of one’s earnings to distributions—but this would be an incorrect assumption. In practice, the IRS is careful to notice whether a salary is reasonable by industry standards. If it determines a salary to be unreasonable, the IRS will not hesitate to reclassify distributions as salary.

Still, while the potential employment tax savings may make the S corporation an attractive structure for your business, bear in mind that you would then have to deal with all the paperwork associated with payroll tax. The payroll tax is a pay-as-you-go tax that must be paid to the IRS regularly throughout the year–on time, or you will incur interest and penalties. The paperwork alone can be an overwhelming task for someone who is not familiar with this; and if you expect to incur losses or otherwise experience a cash flow crunch during the year that would hinder you from paying the payroll tax when due, this could present a problem.

Owners of LLCs pay their self-employment tax once a year on April 15 when income taxes are normally due. Income tax filings are also relatively easy for the owners of an LLC: A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor; partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.

The comparison chart below sums up the similarities and differences between the two business structures:

S Corporation Limited Liability Company
Liability Protection Yes Yes
Operational Control Board of Directors/Officers May be member-managed or manager-managed
Federal Income Tax Pass-through Pass-through
Flexibility/Ease of Operation No; subject to some formalities and record keeping rules as traditional C corps Yes 
Ownership Restrictions Yes No
Flexibility in Profit-Sharing No Yes
Employment Tax Employment/payroll tax on salary; no employment tax on dividends paid to shareholders Self-employment tax on total net income *

There is no one, magical entity that works for everyone. A CPA or a specialized tax attorney can assist you in choosing the right structure for your business. The important thing is to consider the operational, legal and tax aspects of each structure as they apply to your unique situation.

* The self-employment tax rate for 2011 is 13.3% (10.4% for social security and 2.9% for Medicare). For self-employment income earned in 2010, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).

For both 2010 and 2011, only the first $106,800 of total net income is subject to the social security portion of the tax. All of the the total net income is subject to the Medicare portion of the tax. (Source: IRS http://www.irs.gov/businesses/small/article/0,,id=98846,00.html)

*For those who prefer the tax treatment of an S corp but like the simplicity of an LLC, there is an alternative worth considering: Forming an LLC that is taxed as an S corp. An LLC may make a special election with the IRS to be taxed as an S corp. This election is made on IRS Form 2553 and must be filed with the IRS before the 16th day of the third month of the tax year in which the election is to take effect.

An LLC that is taxed as an S corp is still a limited liability company from a legal standpoint (subject to the laws governing limited liability companies in the state of formation); however, for tax purposes it is treated as an S corp.

A word of caution: Certain nuances of S corp taxation can be confusing to some LLC owners, especially do-it-yourselfers and/or those who prepare their own tax returns; for example, an LLC owner might easily make the mistake of referring to an that addresses LLCs when, in fact, such a publication would not apply to an LLC that is taxed as an S corp–and such an error could lead to negative tax consequences. It is therefore highly recommended that you consult a CPA or other qualified tax professional for advice and/or assistance.

 

by Chrissie Mould

IRS Forms/Publications

The publications listed below are located on the IRS Web site and require Adobe Acrobat Reader to view. Visit the Adobe Web Site to install the latest version of Acrobat Reader.

Click a publication to view it online.

Publication 1   Your Rights As a Taxpayer
Publication 3 Armed Forces’ Tax Guide
Publication 15 Circular E, Employer’s Tax Guide
Publication 15A Employer’s Supplemental Tax Guide
Publication 17 Your Federal Income Tax
Publication 51 Circular A, Agricultural Employer’s Tax Guide
Publication 54 Tax Guide for U.S. Citizens and Resident Aliens Abroad
Publication 80 Circular SS – Federal Tax Guide for Employers in the U.S. Virgin Islands, Guam, American Samoa, and the Commonwealth of the Northern Mariana Islands
Publication 225 Farmer’s Tax Guide
Publication 334   Tax Guide for Small Business
Publication 378 Fuel Tax Credits and Refunds
Publication 463 Travel, Entertainment, Gift, and Car Expenses
Publication 501 Exemptions, Standard Deduction, and Filing Information
Publication 502 Medical and Dental Expenses
Publication 503 Child and Dependent Care Expenses
Publication 504 Divorced or Separated Individuals
Publication 505 Tax Withholding and Estimated Tax
Publication 509 Tax Calendars
Publication 510 Excise Taxes
Publication 513 Tax Information for Visitors to the U.S.
Publication 514 Foreign Tax Credit for Individuals
Publication 515 Withholding of Tax on Nonresident Aliens and Foreign Corporations
Publication 516 U.S. Government Civilian Employees Stationed Abroad
Publication 517 Social Security and Other Information for Members of the Clergy & Religious Workers
Publication 519 U.S. Tax Guide for Aliens
Publication 521 Moving Expenses
Publication 523 Selling Your Home
Publication 524 Credit for the Elderly or the Disabled
Publication 525 Taxable and Nontaxable Income
Publication 526 Charitable Contributions
Publication 527 Residential Rental Property (Including Rental of Vacation Homes)
Publication 529 Miscellaneous Deductions
Publication 530 Tax Information for First-Time Homeowners
Publication 531 Reporting Tip Income
Publication 533 Self-Employment Tax
Publication 535 Business Expenses
Publication 536 Net Operating Losses
Publication 537 Installment Sales
Publication 538 Accounting Periods and Methods
Publication 541 Partnerships
Publication 542 Corporations
Publication 544 Sales and other Dispositions of Assets
Publication 547 Casualties, Disasters, and Thefts
Publication 550 Investment Income and Expenses (Including Capital Gains and Losses)
Publication 552 Recordkeeping for Individuals
Publication 554 Older Americans’ Tax Guide
Publication 555 Community Property
Publication 556 Examination of Returns, Appeal Rights, and Claims for Refund
Publication 557 Tax-Exempt Status for Your Organization
Publication 559 Survivors, Executors and Administrators
Publication 560 Retirement Plans for Small Business
Publication 564 Mutual Fund Distributions
Publication 570   Tax Guide for Individuals With Income from U.S. Possessions
Publication 571 Tax-Sheltered Annuity Programs for Employees of Public Schools and Certain Tax-Exempt Organizations
Publication 575 Pension and Annuity Income
Publication 583 Starting a Business and Keeping Records
Publication 587 Business Use of Your Home (Including Use by Day-Care Providers)
Publication 590 Individual Retirement Arrangements (IRAs)(Including SEP-IRAs and SIMPLE IRAs)
Publication 593 Tax Highlights for U.S. Citizens and Residents Going Abroad
Publication 595 Tax Highlights for Commercial Fishermen
Publication 596 Earned Income Credit
Publication 598 Tax on Unrelated Business Income of Exempt Organizations
Publication 721 Tax Guide to U.S. Civil Service Retirement Benefits
Publication 901 U.S. Tax Treaties
Publication 907 Tax Highlights for Persons With Disabilities
Publication 911 Direct Sellers
Publication 915 Social Security and Equivalent Railroad Retirement Benefits
Publication 919 How Do I Adjust My Tax Withholding?
Publication 925 Passive Activity and At-Risk Rules
Publication 926 Household Employers Tax Guide
Publication 929 Tax Rules for Children and Dependents
Publication 936 Home Mortgage Interest Deduction
Publication 939 General Rule for Pensions and Annuities
Publication 946 How to Depreciate Property
Publication 950 Introduction to Estate and Gift Taxes
Publication 954 Tax Incentives for Empowerment Zones and Other Distressed Communities
Publication 957 Reporting Back Pay and Special Wage Payments to the Social Security Administration
Publication 967 The IRS Will Figure Your Tax
Publication 968 Tax Benefits for Adoption
Publication 969 Medical Savings Accounts
Publication 970 Tax Benefits for Higher Education
Publication 1212 List of Original Issue Discount Instruments
Publication 1542 Per Diem Rates
Publication 1544 Reporting Cash Payments of Over $10,000

Definitions

2012 Tax rates:
In 2012, Federal income tax rates were scheduled to increase to pre-2001 levels, but the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” left the existing tax brackets in place through 2012. The income ranges were increased modestly for inflation, but otherwise remained the same as 2010. Below are the resulting tax rates and income ranges for 2012:
Filing Status and Income Tax Rates 2012

Caution: Do not use these tax rate schedules to figure 2011 taxes. Use only to figure 2012 estimates.
Tax rate Married filing jointly
or qualified widow(er) Single Head of household Married filing separately
10% $0 – 17,400 $0 – 8,700 $0 – $12,400 $0 – 8,700
15% $17,400 – 70,700 $8,700 – 35,350 $12,400 – 47,350 $8,700 – 35,350
25% $70,700 – 142,700 $35,350 – 85,650 $47,350 – 122,300 $35,350 – 71,350
28% $142,700 – 217,450 $85,650 – 178,650 $122,300 – 198,050 $71,350 – 108,725
33% $217,450 – 388,350 $178,650 – 388,350 $198,050 – 388,350 $108,725 – 194,175
35% over $388,350 over $388,350 over $388,350 over $194,175
Source: http://www.irs.gov
Filing status
Choose your filing status. Your filing status determines the income levels for your federal tax bracket. It is also important for calculating your standard deduction, personal exemptions, and deduction phase out incomes. The table below summarizes the five possible filing status choices. It is important to understand that your marital status as of the last day of the year determines your filing status.

Filing Status for 2012

Married filing jointly If you are married, you are able to file a joint return with your spouse. If your spouse died during the tax year, you are still able to file a joint return for that year. You may also choose to file separately under the status “Married filing separately”.
Qualified widow(er) Generally, you qualify for this status if your spouse died during the previous tax year (not the current tax year) and you and your spouse filed a joint tax return in the year immediately prior to their death. You are also required to have at least one dependent child or stepchild for whom you are the primary provider.
Single

If you are divorced, legally separated or unmarried as of the last day of the year you should use this status.
Head of household This is the status for unmarried individuals that pay for more than half of the cost to keep up a home. This home needs to be the main home for the income tax filer and at least one qualifying relative. You can also choose this status if you are married, but didn’t live with your spouse at anytime during the last six months of the year. You also need to provide more than half of the cost to keep up your home and have at least one dependent child living with you.
Married filing separately If you are married, you have the choice to file separate returns. The filing status for this option is “married filing separately”.

Dependents
A dependent is someone you support and for whom you can claim a dependency exemption. In 2012, each dependent you claim entitles you to receive a $3,800 reduction in your taxable income (see exemptions below). You may also receive a tax credit of up to $1,000 for each dependent child under the age of 17. The credit is, however, phased out for at higher incomes.

Total exemptions claimed
Each exemption you claim reduces your taxable income by $3,800 for 2012. You receive an exemption for yourself, your spouse and one for each of your dependents.

Capital gain or loss
This is the total capital gain you realized from the sale of assets. This calculator allows you to enter your total short-term capital gain for investments held less than one year and your total long-term gain for investments held at least one year. Any amount you enter as a short-term capital gain is taxed as normal income. Any amount you enter as a long-term capital gain is taxed as follows:

This calculator assumes that all of your long-term capital gains are taxed at either 0% or 15%.

The tax is 0% for the portion of your gain that would have been taxed at 15% or lower tax if it were a short-term gain.

The tax is 15% for any of your capital gain that would have been taxed at a rate higher than 15% if it were considered a short-term gain.

This calculator assumes that none of your long-term capital gains come from collectibles, section 1202 gains or un-recaptured 1250 gains. These types of capital gains are taxed at 28%, 28% and 25% respectively (unless your ordinary income tax bracket is a lower rate).

Capital gains were scheduled to increase in 2012, however the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” left them at their existing rates shown above. For more information on capital gains tax rates and how they are applied, you may wish to read IRS Publication 17: Your Federal Income Taxes.

Business income or loss from Schedule C
Any income or loss as reported on Schedule C.

Income from Schedule E
Rental real estate, royalties, partnerships, S Corporations, trusts, etc.

Total income
Total income calculated by adding lines 7 through 21 on your form 1040. For most taxpayers this includes wages, salaries, tips, interest, dividends and gains and losses from a variety of activities.

Adjusted gross income
Adjusted gross income (AGI) is calculated by subtracting all deductions from lines 23 through 33 from your total income. AGI is used to calculate many of the qualifying amounts if you itemized your deductions.

Taxable income
Your total taxable income is your AGI minus your itemized or standard deduction, and your deduction for exemptions.

Tax
This is the total federal income tax you owe for 2012 before any tax credits.

Total credits
Your total tax credits. This amount is subtracted from the total tax amount.

Total tax after credits
This is the total federal income tax you will need to pay in 2012.

Total other taxes
Any other taxes that you owe for 2012. This includes self-employment tax, alternative minimum tax, and household employment taxes.

Total tax
Grand total of your 2012 federal tax bill.

Total payments
Total of all tax payments made in 2012. This includes tax withheld from Forms W-2 and 1099, and estimated taxes paid, earned income credit and excess social security tax withheld.

Information and interactive calculators are made available to you as self-help tools for your independent use and are not intended to provide investment advice. We can not and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.

Medical Expenses

For 2012, medical expenses can be deducted (as an itemized deduction) only to the extent that total out-of-pocket expenses exceed 7.5% of adjusted gross income. Starting in 2013, this threshold is 10%. This was one of the many tax-related provisions in the health care reform package passed back in 2010.

There’s a wide variety of expenditures than can qualify for the medical tax deduction, including health insurance premiums for individual coverage (that is, not through an employer’s group plan), co-payments for prescription medication and doctor’s visits, dental care, and eye care. Some additional medical expenses that can be deducted: travel to and from medical care, hearing aids and laser surgery to correct vision.

A full list of expenses that qualify for the medical deduction in found in Publication 502 on the IRS Web site.