Tax Advantages of S Corporation Versus LLCs

An S corporation may have several potential advantages as compared to an LLC, or limited liability company.

Before I discuss the relative tax advantages of S corporations versus LLCs, however, I should go over the basics of S corporation and LLC taxation.

Basics of S Corporation versus LLC Taxation

S corporations are created when an eligible entity (traditionally a corporation) elects to be treated according to the rules of Subchapter S of the Internal Revenue Code and its related regulations. S corporations, therefore, are really a tax accounting classification rather than a legal entity.

An LLC, in contrast, is actually a legal entity created by state law through the filing of articles of LLC formation or some similar document.

A second important point: An LLC is a chameleon for tax purposes. LLCs with one owner, or /member/, can be disregarded (or ignored) for tax purposes. And this “ignoring” or “disregarding” just means that the LLC’s activities are reported on its owner’s regular income tax return.

The one-member LLC can also elect to be treated as a regular corporation, called a "C corporation", or it can elect to be treated as an S corporation. (In the language of the applicable Treasury Regulations, an LLC is an “eligible entity.”)

An LLC with multiple owners, or /members/, can be treated as a partnership for tax purposes. The multiple-member LLC also can elect to be treated as a regular corporation or, again, as an S corporation.

To sum up, the legal entity called an LLC can elect to use the S corporation tax accounting classification. (Many people, even professionals who should understand this, unfortunately don’t.)

Once you understand these two points, you can more easily understand the tax advantages of S corporation versus LLC status.

Tax Advantages of S Corporation Versus LLCs: Single-member LLCs

A single-member LLC treated as a disregarded entity reports its income and deductions on a Schedule C tax form if the LLC operates an active trade or business. This tax accounting means that the LLC owner pays self-employment taxes (roughly 15% on the first $100,000 of profits and roughly 3% therefore) on all of the LLC’s profits.

In comparison, a single-member LLC operating an active trade or business and treated as an S corporation has to file a corporate tax return and regular payroll tax returns. However, the S corporation status means that the business pays Social Security and Medicare taxes equivalent to self-employment taxes (again roughly 15% on the first $100,000 of profits and then 3% on profits after that) only on the amount of profit called “wages.”

To show you how powerful this self-employment tax saving gambit can be, suppose that an LLC makes $100,000 in profits. If the LLC is treated as a sole proprietorship, the self-employment tax bill roughly costs $15,000 each year.

If the LLC is treated as an S corporation and the owner, wage amount is set to $50,000, the self-employment tax bill roughly costs $7,500 each year.

S corporation status in this example saves the owner roughly $7,500 annually in employment taxes.

Note: A single-member LLC that doesn’t operate an active trade or business doesn’t have to pay self-employment tax and so would not save self-employment taxes by electing S corporation status.

Tax Advantages of S Corporation Versus LLCs: Multiple-member LLCs

A multiple-member LLC is treated as a partnership unless it makes an election with the IRS to be treated as a regular C corporation or as an S corporation.

As compared to a multiple-member LLC, an S corporation provides two significant advantages. First, a partner’s earnings from a partnership engaged in an active trade or business are subject to self-employment taxes. Accordingly, by electing to have a multiple member LLC treated as an S corporation, the LLC saves the owners self-employment taxes in the same way that an LLC treated as a sole proprietorship saves its owner self-employment taxes.

This is a bit redundant, but to show you again how this self-employment tax saving works, suppose that an LLC makes $200,000 in profits and has two members who each receive half of the profits. If the LLC is treated as a partnership, each partner receives $100,000 of earnings and each partner’s self-employment tax bill roughly costs $15,000 each year.

If the LLC is treated as an S corporation and the owner wage amounts are set to $50,000, the self-employment tax bill roughly costs $7,500 per partner each year.

S corporation status in this example saves each partner roughly $7,500 annually in employment taxes.

Note: If an LLC with multiple members has both members who actively work in the business and other members who can’t make decisions and don’t work in the business, a special type of LLC can be created that also provides for self-employment tax savings even though the LLC is treated as a partnership. Typically, only large LLCs will have the resources to pay for the attorney and accountant help necessary to set up and cleanly operate one of these special LLCs. What makes the LLCs special, by the way, is that they comply with proposed Treasury Regulations dealing with LLCs that resemble limited partnerships by having both active,“general partner”-like members and passive ,“limited partner”-like interests.

One other point should be made about the tax advantages of S corporations versus LLCs that have multiple members. As noted earlier, an LLC with multiple members is treated for tax purposes as a partnership. Partnerships are wonderfully powerful tax-planning tools. A partnership presents its partners with a myriad of opportunities to save taxes. However, partnership status also complicates the tax accounting. An LLC treated as a partnership, for example, requires more complicated and more expensive accounting than an LLC treated as an S corporation.