S-Corporation or LLC: Which is Better for Your Management Company?

Owners of management companies often choose a business form that provides pass-through taxation to avoid paying taxes at both the corporate and personal level. Both an S-corporation and a Limited Liability Company (LLC) provide a way to do this, but several key differences come into play. The following comparisons of the two business entity types provide some considerations to help you decide whether to structure your management company as an S-corporation or an LLC.

Pass-Through Taxation

An S-corporation offers some of the tax advantages of a pass-through entity while providing the limited liability protection of a C-corporation. S-corporations generally allow income to pass through to shareholders, avoiding the double taxation issues that C-corporations face when taxes are first paid at the entity level and then again on dividends received at the individual shareholder level.

An LLC protects its owners, known as members, with limited liability like a corporation but allows pass-through taxation like a partnership. A multimember LLC’s default tax classification is a pass-through partnership, but it can elect to be classified as a partnership or a corporation.

Self-Employment Tax

One of the primary differences between an S-corporation and an LLC is that the net taxable income that an S-corporation allocates to its shareholders is not subject to federal self-employment tax. By contrast, the income that an LLC allocates to its members requires certain analysis to determine whether self-employment taxes apply, and members of an LLC may be subject to self-employment taxes on all profits.

Formation and Formalities

Legally, an S-corporation is a corporation and is required to maintain certain formalities, including having a board of directors, adopting bylaws, issuing stock, holding annual meetings and keeping minutes with corporate records.

LLCs, by contrast, are generally easier to set up and maintain, with fewer formalities and rules. This makes them generally more flexible than S-corporations.

Jurisdictions

Both S-corporations and LLCs are legal structures under state law. Certain jurisdictions, like New York City, do not recognize S-elections and tax them as C-corporations.

Ownership

S-corporations can have a maximum of 100 shareholders. Those shareholders must be U.S. citizens or legal residents and cannot be associated with other C-corporations, S-corporations, LLCs, partnerships or certain trusts. Additionally, the S-corporation can have only one class of stock, as all shareholders must have the same voting rights.

LLCs have fewer ownership restrictions than S-corporations do. There is no limit to the number of members. Members can also be non-U.S. residents, and they can be any type of investor. Additionally, LLCs allow for multiple classes of ownership to accomplish the economic results that taxpayers require in complex deals, structures or negotiations.

Allocation

There are also some differences with allocations. An S-corporation must allocate taxable income, loss, contributions or distributions between shareholders based on their relative ownership percentage. This means that no special allocations of any kind are permissible.

The allocation requirements for an LLC are more flexible than those for an S-corporation. Special allocations are permitted as long as they follow the terms of the LLC’s Operating Agreement and comply with certain IRS requirements.

Salary vs. Guaranteed Payments

S-corporation shareholders must pay themselves a “reasonable salary,” which is determined based on all facts and circumstances. Given that a reasonable salary could be different across taxpayers and industries, the IRS could argue that the S-corporation is not paying a high enough salary to the shareholders and is therefore lowering the amount of self-employment taxes paid on the salary. Shareholders who receive a salary from the S-corporation will also receive Form W-2 with the associated payroll taxes withheld on their behalf. This may alleviate or reduce the amount of quarterly estimated taxes that the individual taxpayers must remit.

LLC members cannot be treated as employees and cannot receive a salary. Instead, they may receive guaranteed payments, which are reported to them on their Schedule K-1 from the LLC. There is no federal tax withholding on guaranteed payments, meaning that LLC members will have additional tax obligations to calculate and submit quarterly estimated taxes at the individual taxpayer level.

If you need help navigating the S-corporation or LLC landscape, Weaver can help. Contact us today to learn more.

Authored by Minh Dinh

©2024