In our previous post, we discussed the fundamental differences between limited liability companies and S-Corporations. Those distinctions include the obligations of the entities and their owners when it comes to taxation.
As discussed in the prior post, both LLCs and S-corps are “pass-through” entities for tax purposes, which means business profits pass through the business entity and get taxed as the personal income of the owners. However, each kind of entity has different requirements and limitations that can be complicated and create problems for owners if they aren’t followed. Some key tax-related issues for these entities include:
- Tax Filing Requirements. An LLC files its tax returns on April 15 just like an individual, and a single member LLC files a 1040 and a Schedule C. The LLC files a form 1065 Federal partnership return and the members each get K-1s. LLCs file State form 568 and have to pay an annual franchise fee of $800 and may have to pay a gross receipts tax as well.
- Profit allocation. LLCs can allocate profits, losses and expenses based upon agreement between the members. Thus, members who work more than other members can be allocated a higher percentage of income than their membership percentage. S Corporations must allocate profits, losses, and expenses based upon an agreement between the members. Thus, members who work more than other members can be allocated a higher percentage of income than their membership percentage. S-Corps must allocate profits and losses based strictly upon share ownership.
- Employment taxes. LLC members are considered to be self-employed. As a result, all income from the LLC will be subject to the 15.3% self-employment and Medicare tax. In contrast, only the wages of S-Corp employees are subject to employment taxes. Any remaining income paid to a shareholder will be treated as a “distribution” which may not be taxed at all in some cases. While shareholders will be taxed on all S-Corp profits when reported, income and distributions won’t always be taxed. If a shareholder is taxed on income, but does not take a distribution, then new distributions won’t be taxed until prior years taxed amounts are distributed. Although this sounds good, shareholders who work for an S-Corp must be paid reasonable compensation for the work they perform. Thus, if you work as an attorney, you can’t show a ten dollar-an-hour pay rate and allocate the remainder to “distributions.” This may bring unwelcome IRS attention.
- Treatment of debt. Members of an LLC can add LLC debt proportionately to their tax basis in their membership interest. This is important if the LLC will have losses. Often newly formed LLCs will have losses so this characteristic can be quite valuable. Shareholders of S-Corp can only increase their share basis by loans they personally make to S Corporation.
Yee Law Group Inc., L.L.P.: Sacramento/Roseville Business and Tax Attorneys
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This article has been prepared by Yee Law Group Inc., PC for informational purposes only and does not, and is not intended to, constitute legal advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.