1. Employment Tax Treatment
S corporations are treated more favorably than LLCs for employment tax purposes. This is an important consideration that can be controlling in the decision of many businesses about whether to operate as an LLC or S corporation.
If all members of an LLC are individuals and participate in management of the LLC’s business, all of the LLC’s income is subject to self-employment tax. What’s more, the income is subject to self-employment tax in the year the LLC earns it even if the income is not distributed to members but is retained by the LLC to provide working capital or to acquire capital assets. Only certain limited types of LLC income, such as capital gains and rentals from real property, are exempt from self-employment tax. If an LLC is organized as a manger managed entity and has members who do not participate in management, income allocated to members who do not participate in management may also be exempt from self-employment tax.
In comparison, income of an S corporation is never subject to self-employment tax in the hands of its shareholders. Wages and salaries paid by S corporations to their shareholders are, however, subject to employment taxes in the same manner as compensation paid by to any other employee. The combined rate of employment taxes imposed on the employer and employee is the same as the rate of the self-employment tax, so the difference in tax systems does not create any savings. But what does create a savings is that employment taxes are only imposed on amounts paid out by an S corporation as compensation. Income of an S corporation that is retained by the business or is paid out as dividends is not subject to employment tax.
Self-employment tax is not a nickel and dime issue. The tax is imposed at a rate of 15.3% on selfemployment income of up to $90,000 received by an individual in 2005, and is imposed at the rate of 2.9% on self-employment income in excess of that amount. Although one-half of an individual’s self-employment tax is deductible for income tax purposes, the imposition of self employment tax as well as income tax on LLC income allocated to a member can significantly increase the rate of tax on the income.
2. Cash Basis Accounting
If a business has owners who do not participate in the operation and management of the business, it may be required to use accrual basis accounting if it is organized as an LLC, even if it does not have inventories or does not have a member that is a C corporation. This is the result of tax rules designed to prevent certain syndications from using cash accounting. These rules generally do not apply to S corporations.
3. Familiar Management Structure
Most states base their corporate laws on model legislation that has been widely adopted or base their corporate laws on long-standing concepts recognized in other states. As a result, there is a large body of law relating to the management and operations of S corporations, and this may reduce the number of potential areas for conflict between shareholders, directors, and officers.
In contrast, the LLC laws of many states differ significantly from those of other states, and all LLC statutes are of relatively recent origin. Consequently, there may be more questions about the proper way to operate or manage an LLC. If you have questions about S corporations and are thinking about forming a new company, contact the Utah Business Formation Attorneys at SLF today and Get Protected!