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What are the Tax Differences Between an LLC and an S Corporation?

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Question: What are the Tax Differences Between an LLC and an S Corporation?
Both the s corporation and the limited liability company have benefits and drawbacks, depending on the particular situation of your business and the state or states in which you do business. Attorney Robert Warwick discusses these two types of business legal forms from a tax perspective. He also suggests that there are many variations, depending on your state, so please check with your state's business division (within the Secretary of State's office), or with your attorney, for more information.
Answer:

Q: Is there a difference between single-member LLC or multiple-member LLC compared to an S corporation, from a tax perspective?

A single-member LLC, a multi-member LLC and an S corporation are all “pass-through entities” because the entity’s income is not taxed to the entity itself but instead passes through to the owners. However, there are differences among the types of pass-through entities in the way in which this is done:

  • In the single-member LLC, the sole owner simply includes the entity’s revenues and expenses on the owner’s tax return (on schedule C) and claims any tax credits generated by the entity in the same manner as if the owner operated as a sole proprietor. For income tax purposes, the single-member LLC is treated as non-existent (for this reason, in “taxspeak” a single-member LLC is referred to as a disregarded entity).
  • In contrast, a multi-member LLC determines its income, deductions, gains, losses, and tax credits (collectively referred to as “tax attributes”) at the entity (business) level and then allocates them among its owners. In most cases, the LLC will be governed by an operating agreement which will specify the manner of allocating tax attributes. The multi-member LLC has a great deal of flexibility in allocating tax attributes, however the income tax regulations impose some limitations, generally to prevent allocations which serve to distort economic reality, say by allocating the lion’s share losses to owners with high income outside of the LLC while allocating the lion’s share of the profits to owners with low income or losses outside of the LLC.
  • The S corporation also determines its tax attributes at the entity level and then allocates them among its shareholders. The S corporation has less flexibility in allocating than the multi-member LLC because the S corporation must allocate tax attributes equally to each share. If the S corporation has only one shareholder, all of its tax attributes will be allocated to that shareholder.

Paying Income Taxes
The multi-member LLC and the S corporation (even if it has only one shareholder) report their income and tax attributes on information returns (Form 1065 in the case of the multi-member LLC; Form 1120-S in the case of the S corporation) and provide each owner with a Schedule K showing that owner’s allocation of the entity’s tax attributes.

Self-Employment Taxes
The owners of LLCs (single- and multi-member) are also treated differently from S corporation shareholders in the way they pay employment taxes. The LLC owner is self employed; accordingly the owner is subject to self employment tax (“SECA”). In 2010, the SECA tax rate is 15.3% on the first $106,800 and 2.9% on amounts in excess of $106,800, with 50% of the SECA tax deductible on the owner’s income tax return. The LLC owner’s entire share of the LLC’s income is deemed to be earnings from self employment subject to SECA.

The S corporation shareholder who works for the corporation, on the other hand is an employee whose reasonable compensation is subject to FICA (Social Security and Medicare taxes). Half of FICA tax is paid by the employee and half by the S corporation employer. The employer’s half is deductible. In 2010, the FICA tax rate on each of the employee and the employer is 7.65% on the first $106,800 and 1.45% on amounts in excess of $106,800. If the S corporation pays a shareholder-employee reasonable compensation, amounts distributed as corporate earnings will not be subject to FICA.

Taxes to owners
As discussed above, both S corporations and LLCs are pass-through entities and taxes on their income are passed through to and paid by their owners. However the entity may be responsible for taxes other than income taxes, for example property taxes on property owned by the entity, employment taxes with respect to the entity’s employees and sales and use taxes.

Robert Warwick has practiced tax and corporate law for more than 35 years, both in private practice and as in-house counsel for two major corporations. He is presently counsel to ThompsonMcMullan, a Richmond, Virginia law firm. He holds JD and MBA degrees from Cornell University and a Bachelor of Electrical Engineering from Rensselaer Polytechnic Institute. Mr. Warwick is actively practices law in Virginia and does not claim any knowledge as to the particular laws of any other jurisdiction.

Disclaimer: The foregoing does not constitute legal advice and does not create an attorney-client relationship.

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