Starting a Small Business: How does S Corp Taxation Compare to LLC Taxation?

When many people think about S Corps and LLCs, they think that the two are different types of entity structures.  In reality though, “S Corp” is a taxation election, not a separate business entity.  As an S Corp, income, losses, deductions and credit pass through to their shareholders for federal tax purposes.  Typically, LLCs are taxed as partnership flow-through entities, but they can elect to be taxed as an S-Corp under certain circumstances.

What is S Corp Tax Status?

To qualify for S Corp status, the corporation or LLC must meet the following requirements:

  • Be a domestic corporation or LLC
  • Have only allowable shareholders or members
    • including individuals, certain trust, and estates and
    • may not include partnerships, C-corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have one class of stock
  • Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.

How are LLCs Taxed?

The federal government does not recognize an LLC as a classification for federal tax purposes. Thus, an LLC business entity must file either a corporation, partnership, or sole proprietorship tax return.  An LLC that is not automatically classified as a corporation can file Form 8832 to elect their business entity classification.  An LLC with at least 2 members can choose to be classified as an association taxable as a corporation or a partnership, and an LLC with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a “disregarded entity.”

Some Differences Between S Corp Election and LLC Partnership Taxation

Personal Liability:  Shareholders in a corporation taxed as an S Corp and members in an LLC (taxed as either an S Corp or a flow-through partnership) are typically not held personally responsible for business debts and liabilities.

Taxation:  For both an S Corp and an LLC, there is no tax at the entity level.  Rather, the income in both the S Corp and LLC are passed through to the shareholders or members.  Thus, neither an LLC nor an S Corp are subject to double taxation.

Self-Employment Tax:  In both an S Corp and an LLC, salary is subject to self-employment taxes.  In an S Corp, however, shareholder distributions are not subject to employment tax.

Transferability of Interest:  In an S Corp, interest is transferable if done in compliance with IRS regulations concerning who can own stock.  With LLCs, interest may be transferrable, but if and how such transfers are made depends upon the restrictions outlined in the operating agreement.