IRS Regulations for S Corp vs LLC: a CPA Explains
By Greg DeFoor
One of the questions I get asked by aspiring or new business owners as a CPA and Business Broker is about S Corporations vs LLCs. Before deciding whether to form an S Corp or an LLC, there are a number of issues to consider. Assuming there is only one owner or a few owners and that all owners are qualified to own their respective shares or member units, here are factors to consider.
More Formal vs Less Formal
S corporations are more formal and require a little more in terms of documentation. When you form a corporation and elect S Corp status, you are required to elect officers and hold annual shareholder meetings. You need corporate bylaws in writing when you establish the corporation. You need to prepare minutes no less than annually that document decisions made during the year. It would be wise to get an attorney to help you with a form or template for completing these minutes.
LLCs are less formal. Once you form an LLC and prepare an operating agreement, there is no requirement for minutes or annual meetings.
Net Income and Distributions
Net income and distributions are not necessarily treated the same in S Corps and LLCs. In an S Corp, net income must be allocated based on ownership percentage. Distributions must be made by ownership percentage. In an LLC, there can be a disproportionate allocation of net income and unequal member draws. When there is only one owner, there really won’t be a difference. However, when there is more than one owner, S Corp shareholders are treated equally in terms of allocated items, and LLC members are treated based on how the operating agreement says they will be treated.
If you need an entity that allows for owner treatment that varies from ownership percentage, an LLC will allow that whereas an S Corp will not.
Guaranteed Payments vs Salary and Self-Employment Tax
In an LLC, you should not pay yourself a salary. Instead, you should take guaranteed payments. Guaranteed payments are subject to self-employment tax but are not paid as W-2 wages. They are treated more like a draw than as payroll. In an S Corp, you need to pay yourself a reasonable salary.
The net earnings from an LLC, except for earnings from the net rental of real estate held for investment, are subject to self-employment tax. The net earnings of an S Corp are not. One of the primary benefits of being a shareholder of an S Corp is the ability to take distributions that are not subject to self-employment tax. You are taxed on the net income of the S Corp. You pay yourself a reasonable salary, and any other net income may be distributed as a shareholder distribution.
Disregarded Entity and Tax Returns
If you are a single member LLC, you are a disregarded entity for tax purposes and the LLC income and expenses flow through your personal tax return on Schedule C. If there are more than one member of the LLC, the LLC files a partnership return. An S Corp files a corporate tax return specifically for S corporations. Both a partnerhip and S corporation are flow through entities. Neither pays income tax at the entity level; rather, both pass taxable income and other tax items directly through to the owner’s individual tax return.
To further complicate matters, an LLC can be an LLC for legal purposes but can also elect to be taxed as an S corporation for tax purposes. If an LLC elects S Corp status for tax purposes, tax matters have the attributes of an S corporation.
Distributions of Property
An S Corp is not necessarily a good entity to hold appreciating property in. That is why S Corp owners who also own the business real estate usually own the business real estate in a separate entity that is an LLC. The reason is usually a tax reason. You can’t distribute appreciated property, such as real estate, out of an S Corp to the S Corp shareholders without triggering a taxable event as if the real estate had been sold. With some restrictions and limitations, you can distribute appreciated property, such as real estate, out of an LLC to the LLC members without triggering a taxable event. In an LLC, the members assume the basis of the distributed property and there is no realizable gain or loss until the property is disposed of.
In order to be an S Corp, you form a corporation and then you file an election to be taxed as an S corporation with the IRS. The election is filed on IRS Form 2553. You must file the election within 75 days of the start of the year you want to elect S Corp status, or within 75 days of forming the entity if you want to elect S Corp status from the beginning.
If you file an LLC for legal purposes but want it to be taxed as an S Corp, you file the same type of election for the LLC you do for a corporation, with the S Corp election for an LLC also having the 75 day requirement.
The catch is, once you elect for either your corporation or LLC to be taxed as an S Corp, you cannot revoke the election. The S Corp election can only be terminated by filing a request with the IRS and receiving permission from the IRS for the S Corp status to be terminated. For this reason, electing S Corp status needs to be entered into carefully, as it cannot be easily undone.
S Corp vs LLC
In deciding S Corp vs LLC, seek advice of a tax professional and an attorney, and find out both the legal and tax reasons for electing one entity over the other. There is certainly more involved than what this article can cover, but this article should be enough to let you know there are a number of things to consider before choosing choice of entity for your business. Make sure you use an advisor that is familiar with business transaction services.
Greg DeFoor, CPA, CFE, has been a CPA for more than thirty years and is also a licensed Business Broker and Past President of the Georgia Association of Business Brokers.