Tax Differences Between LLC and S Corporations

A frequent question that gets asked is, "what is the difference between a limited liability company (LLC) and an S Corp?"  There are some structural and management differences between the two which I will address in a future blog post. But for now, I’ll will focus on the tax differences between the two.

First, an S Corporation is really just a corporation that has chosen to be treated as a pass through entity.  Meaning profits and losses should pass through to the shareholders, thereby avoiding an entity level tax (and avoiding the dreaded "double taxation."  It is strictly a tax election.   An LLC is also a pass through entity, essentially a partnership with limited liability properties.

But there are subtle tax differences between the two.  For the purposes of this article I will assume for the most part that all owners of either entity also participate in the management of the company, which is how a lot of very small businesses operate.

Retained Earnings

When you employ yourself your salary is subject to a self-employment tax.  The self-employment tax is basically the FICA tax you see on paychecks (Social Security and Medicare) plus the employer’s portion. This amounts to 15.3% so it is not a trivial amount, however you get to deduct 1/2 of this as an expense.

In an S corp, if you retain any earnings that amount will not be subject to the self-employment tax.  Companies retain earnings to have a cash cushion, to make capital investments, etc.  If you retain earnings in an LLC, the owners would still be subject to the tax whether they received the funds or not.

Dividends

In an S Corp, if after you pay the owners a "reasonable salary" there is money left over for a dividend, this amount would also not be subject to the self employment tax.  What a "reasonable salary" is varies, so be sure you consult your tax advisor before declaring a salary.  In an LLC there are no provisions for dividends.  Everything is subject to the SE tax unless the dividend goes to a non-manager/worker owner; in the case of the S Corp the party receiving the dividend can also be an employee.

Misc. Differences

LLC’s are more transparent therefore owners can contribute and withdraw property tax-free for the most part.  For S Corps this applies usually only at incorporation unless the contributing owner is an 80% or more owner.  For LLC owners, they allow inclusion of LLC debt in basis (to take advantage of losses, if any), disproportionate allocations and distributions.

California Differences

Note that the above differences apply at the Federal IRS level.  States may treat the two differently.  California treats the two entities slightly different as well.  California applies a 1.5% flat tax on all income of an S Corporation.  LLC’s have a minimum $800 franchise tax plus what’s called an LLC fee based on gross receipts (not income), which can be seen in California FTB Publication 568 on page 5.

Conclusion

So there you have some of the minor differences.  The differences may be minor for some, and may be major for others. In some cases the differences may not even matter if some other overriding factors cause you to choose one entity over another.  The key point is that before you sit down and choose an entity, you make the choice based on specific circumstances related to your business or business plan.