Both the LLC and S corporation are well-liked among accountants and small businesses because of their “pass-through” tax treatment. Unlike a C corporation, both of these structures do not pay taxes on business profits; rather profits are passed along to the owner(s) and reported on their individual tax returns. Moreover, both structures separate the owners from the business and provide liability protection.
However, there are some differences between the two. For example, an LLC is typically much easier to run from an administrative standpoint. There are fewer state filings and forms, lower start-up costs, fewer formal meetings and documentation than there are with a C or S corporation. This conceivably could be advantageous to small business owners who don’t want to be bothered with excess paperwork.
The LLC also offers more flexibility in how owners can allocate a percentage of profits and losses among its owners. Example: you start a business with a friend and you each own 50 percent of the business. One year, your friend has something come up in her personal life and doesn’t spend as much time on the business as you have. You both ultimately decide that the fair thing to do would be to give you 60 percent of the profits for the year. If you had formed an S corporation, you would both still be taxed based on the percentage of your ownership (i.e. you would be taxed on 50 percent of the profits; your fellow shareholder on 50 percent, even though you might have agreed to a different “arrangement”). Conversely, the LLC does give you the flexibility to determine how you want to allocate your business’ profits so that each owner canl be taxed accordingly.
Nevertheless, there is a critical advantage of an S corporation with regard to taxes. The S corporation gives you more flexibility in how earnings are paid to the owners. Example: with an LLC, the entire net earnings are passed along to the owner(s) in the form of self-employment income and are consequently subject to self-employment tax for Social Security and Medicare. However, with the S corporation, you have the option of dividing up earnings into wages/salaries versus passive income in the form of distributions. Only the wages/salaries are subject to the FICA tax for Social Security and Medicare. The “passive” distributions are not. IMPORTANT NOTE: keep in mind that as an owner working in your business, you must pay yourself a reasonable salary for the job you do. You cannot get away with giving yourself a $40,000 annual salary and taking $175,000 in distributions, for example.
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