LLCs and Subchapter S Corporations share a number of characteristics. Chief among them is that each provides participants – shareholders in a corporation, members in an LLC – with insulation from personal liability while avoiding the “double taxation” associated with C-Corporation status. Double taxation means that a C-Corporation pays taxes on profits and its shareholders pay taxes on distributions. However, Sub-S Corporations do not pay taxes at the corporate level.
Sub-S Corporations are corporations, meaning that the statutory requirements of the form apply. Sub-S Corporations must hold annual meetings of shareholders and directors, conduct annual elections and file annual reports with the State Corporation Commission. Conversely, the LLC structure requires none of these things, allowing it to operate unimpeded by statutorily imposed formalities.
Additionally, the federal tax code imposes strict limits on Sub-S Corporations, restricting membership to 100 shareholders, each of whom must be a U.S. citizen or legal resident. With some limited exceptions, all shareholders must be individuals. Hence, a Sub-S Corporation cannot own another Sub-S Corporation, but an LLC can own other LLCs.
Ownership Advantages and Disadvantages
In a Sub-S Corporation, profits must be distributed in proportion to ownership interest. In contrast, LLCs have the flexibility to uncouple ownership from profit interest. Additionally, a Sub-S Corporation can have only one class of stock, while LLCs may be composed of multiple classes of members with differing rights. Generally speaking, owners of single member LLCs will pay self-employment taxes (Social Security and Medicare) on all of their income. Owners of a Sub-S Corporation must pay, or attribute to themselves, a “reasonable” salary. Self-employment taxation is limited to income designated as wages rather than all distributions. The benefit here is that a Sub-S Corporation can deduct payroll expenses like federal taxes and FICA and any remaining income above the set salary is distributed as dividends, which is taxed at a lower rate.
What to Choose?
There is no one size fits all answer to the perpetual question of preferred form of business entity. LLCs and Sub-S Corporations have obvious similarities, but their dissimilarities are equally significant. The entrepreneur and his or her advisors should carefully consider these distinctions, matching the characteristics of the entity form to the business goals.