Introduction: Your LLC may be taxed in one of the following four ways depending on the tax result you want:
- Partnership; or
- Pass-through entity.
Your corporation may be taxed only as either:
- a C-Corporation; or
- an S-Corporation.
We discuss these alternatives in more detail elsewhere on our website. Our advice, for almost all small businesses, is to organize your business as an LLC primarily because of the incredible operating flexibility allowed the LLC under state statutes. This flexibility that does not apply to a corporation, which is bound by a morass of rules and regulations that are difficult for small business operators to navigate. Further to this, taxation as a partnership allows most if not all the tax benefits received by an S-Corp.
This article focuses on the income taxation of your LLC or corporation as an S-Corporation. It is confusing, but your LLC can be taxed as an S-Corporation or a C-Corporation; so, for simplicity, I will refer to your LLC or corporation as an S-Corp. in this article.
Electing to be taxed as an S-Corp. requires a physical filing with the IRS on Form 2553 and is more time consuming as a result. The IRS during COVID fell behind on these applications, creating very real difficulties for people organizing their businesses and obtain identification numbers to open bank accounts and establish trade relationships.
The S-Corp., simply put, allows the passing through of income (along with credits, deductions, and losses) to its owners; however, the IRS requires that the entity:
- be organized in the United States;
- not have more than 100 equity holders;
- have no more than one class of equity interest; and
- have, for the most part, individuals as equity owners.
- Limited liability for management and owners. This is also provided to any corporation and LLC. Wyoming also suspends most operational formalities with its “close” status for family businesses, a real boon for maintaining limited liability.
- Perpetual existence. This leaves the timing of termination and dissolution of the business to its owners as and when appropriate.
- No double taxation. Pay tax only at the ownership level and not at both the entity and ownership level (i.e., no double taxation). The C-Corp. pays a maximum 21% at the entity level, but when distributions take place, the owners are further taxed at their personal income tax levels. This is the double taxation issue. Many small business owners mistakenly believe they can somehow avoid double taxation in the future, but that is not realistic. There are tables available online to compute if C-Corp. status will benefit you, but the results show that this 21% tax differential when you factor in double taxation is not worth it in the long run and provides only some short-term benefits in most cases.
- Lower personal tax tab for owners. This occurs when owner lower their self-employment tax through the receipt of money from the S-Corp. as salary or dividends. Owners may also include individuals in very low personal income tax brackets, such as retired parents, which allows income tax recognition at very low rates.
- Tax-Fee Dividends. Owners can receive dividends that are tax-free if the distribution does not exceed the basis in their stock. This contrasts with the tax on distributions assessed with C-Corps.
- Credibility. S-Corp. status may help establish credibility with potential customers, employees, suppliers, and investors, although this benefit has become conjectural as LLCs gain popularity. There are commentators who believe this makes a difference, but our experience has been otherwise.
- Investment Opportunities. The business as an S-Corp. can better attract equity investors. Again, this benefit has become conjectural as LLCs gain in popularity.
- U.S. owners and permanent residents only. As globalization continues, this could severely limit your ability to expand as a business since no one outside the U.S. can invest.
- Ownership limited to 100 owners. If your business extends and expands over several generations, this limits family ownership to 100 people. The benefit you receive today will severely limit your family’s ability to extend the business generationally. The 100-shareholder limit generally hits by the third or fourth generation causing a great deal of difficulty in transitioning the entity to either a C-Corp. or a partnership.
- Expenses to Maintain. Formation and ongoing ownership expenses in maintaining the S-Corp. with state authorities can exceed LLC costs.
- IRS Scrutiny. S-Corps. can disguise salaries as corporate distributions to avoid paying payroll taxes. For this reason, the IRS scrutinizes how S-Corps pay employees; however, this is not a real difficulty as an S-Corp. is deemed by the IRS to be paying reasonable salaries if the owners provide services prior to distributions are made, the distributions are ratable, and the dividends are estimable.
- Disproportionate Profit Allocations and Distributions. The S-Corp. is legally required to allocate profits and losses strictly based on the percentage of ownership each owner has. This severely restricts the ability of the S-Corp. to make disproportionate distributions. This is not a limitation, at least initially, for an LLC taxed as a partnership, an ability this firm heartily recommends.
- IRS Termination of Status. The IRS may terminate an S-Corp’s status if you don’t properly allocate profits and losses—or if you take other prohibited actions such as not following your bylaws or operating agreement, with the resulting make mistakes in an election, consent, notification, stock ownership, or filing requirements. These are, however, allowed to be quickly fixed by the IRS and are not a real issue for the IRS, but could be for maintaining limited liability of your S-Corp., as discussed above.
- Paperwork and Delays. Making the S-Corp. election requires additional paperwork with the IRS and delays the opening of the business since the election requires a physical and not an electronic filing.
- Capital Raising. The limits on the number and nature of shareholders become difficult if you are successful and want to attract venture capital or institutional investors.
S-Corp. Tax Return
Your S-Corp. is still required to annually file a Form 1120-S to report its earnings to the federal government, along with a Schedule K-1 to delineate each owner’s proportionate share of the income, losses, dividends, and other distributions during the year. You do not have to file quarterly returns, however.
The Form 1120-S is a simpler than tax form than the return for C-Corps.
S-Corp. vs. LLC
In conclusion, here are the real differences between partnership and S-Corp. taxation:
- Number of Owners: Partnerships can have an unlimited number of owners. S-Corps can have no more than 100 owners.
- Status of Non-U.S. Owners: Partnerships may have non-U.S. citizens/residents as owners. The S-Corp. cannot have non-U.S. citizens/residents as owners. Further, partnerships may be owned by corporations, LLCs, partnerships, and trusts, while S-Corps cannot be owned by corporations, LLCs, partnerships, or many trusts.
- Subsidiaries: LLCs are allowed to have subsidiaries without restriction. S-Corps. are not.
- Classes of Ownership: S-Corps cannot issue classes of stock with different financial rights – such as giving some owners a preference to distributions over other shareholders. LLCs are not subject to similar restrictions.