Business owners looking to avoid the double layer of taxes associated with operating a C-corporation (the absurd taxation of dividends) often consider utilizing an S corporation or a limited liability company. While both structures act as pass through entities for tax purposes, there are noteworthy differences between the two.
Ownership & Profit Allocation – There are several significant restrictions on who can be owners of an S corporation. A shareholder of an S corporation cannot be a nonresident alien and, more importantly, shareholders cannot be other corporations or LLCs. Also, the number of shareholders is capped at 75 for S corporations. An LLC has no restrictions on ownership.
Unlike C corporations that can have varying forms of equity (common stock, preferred stock, etc.), S corporations can only have one form of stock. The result is that S corporations have no flexibility as to how profits are split up amongst its owners. So, even if the owners of an S corporation want to distribute profits in a manner they consider more “equitable,” they cannot do so because all distributions must be made according to the stock ratio of its owners. For LLCs, the owners have great flexibility as to how profits may be distributed.
Employment Taxes – A major difference between an S corporation and an LLC is that the entire earnings of an LLC are subject to a “self-employment-tax.” For self-employment income earned in calendar year 2011 the self-employment tax rate is 13.3% (10.4% for Social Security and 2.9% for Medicare). The 2010 Tax Relief Act reduced the self-employment tax by 2% for 2011, but even at the 13.3% reduced rate the self-employment-tax, in my opinion, is just another example of the federal government stifling free enterprise and the US economy.
For an S corporation, only the salary paid to the employee-owner is subject to employment tax; the remaining income distributed is not. But don’t think that as an S corporation owner you can pay yourself a $10,000 annual salary to minimize your employment tax – the IRS mandates that owner-employees be paid a “reasonable salary.” Therefore, the tax savings may only take effect once the business has a fairly sizable income. In any event, any decision as to what corporate entity should be utilized must be coordinated with your accountant.
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