S Corporation vs LLC: How Each Is Taxed

An LLC and an S corporation are often described as if you had to pick one. You do not. They answer different questions.

What an LLC is

A limited liability company is a legal entity created under state law. It separates the business from its owners for most liability purposes. For tax, the IRS does not have a category called "LLC". Instead it taxes an LLC as one of these:

• A sole proprietorship if it has one owner and has not elected anything else (the income goes on Schedule C of the owner's personal return)
• A partnership if it has two or more owners and has not elected anything else (it files Form 1065 and issues K-1s)
• An S corporation or a C corporation if it elects to be taxed that way

What an S corporation is

An S corporation is a tax classification. A corporation or an LLC that meets the eligibility rules can elect it by filing Form 2553. The business generally does not pay federal income tax itself. Its profit passes through to the owners, who report it on their personal returns.

Why owners look at the S election

Owners of a sole proprietorship, and most active owners of an LLC or partnership, generally pay self-employment tax (Social Security and Medicare) on all of their net business profit. In an S corporation, an owner who works in the business must be paid a reasonable salary through payroll, and the profit left over can be taken as a distribution that is not subject to self-employment tax. That is where a saving can come from.

What it costs you

• Payroll for the owner. You run payroll for yourself, with payroll tax filings.
• A separate return. The business files Form 1120-S every year and issues K-1s.
• More rules. Owner salary must be reasonable, basis has to be tracked, and some benefits are taxed differently.

So which is better?

It depends on profit. At low profit, the extra cost of payroll and an additional return can be more than the tax saved. As profit grows, the election becomes more worth considering. There is no single number that applies to everyone, so it helps to run both calculations for your own figures.

If you are thinking about it, talk to us before you file. The election has a deadline, and the right answer depends on your numbers, your state and your plans for the business.