Gauging from clients in my tax office there is a serious misunderstanding of what an LLC is compared to an S-corporation.
A simple social media inquiry showed many tax professionals also struggle with this issue. One tax pro felt my way of presenting the question misrepresented the facts. What? He went on to say “One is done at the state level, the other at the federal.” For the record, corporations and LLCs are organized at the state level. Only the S-election (the election made to be an S-corp) is handled through the IRS.
And the coup de grâce comes from determining when to use each entity type: sole proprietor, partnership, LLC, regular corporation/C-corp, or an S-corp. Tax professionals following this blog have also asked me to clarify this issue for them as they struggle with which entity to use and when.
We will discuss all these issues and more in this post. By the end of this article you will know the difference between an LLC and S-corp and when to use each.
What is an LLC, S-Corp. . .
First we will define what each entity is.
The sole proprietor is not an entity in itself. If you have non-employee compensation you have business income and report that income as a sole proprietorship, filing Schedule C of the Form 1040 showing said income along with ordinary and necessary expenses.
A single-member LLC by default is a disregarded entity (sole prop or partnership). This means that for tax purposes we act like it doesn’t exist. But the LLC is still there as a legal construct, protecting you in the same manner as if it were regarded for tax purposes.
A non-LLC partnership is also not an entity, per se. The easiest way to think of a partnership is as a sole proprietorship with more than one owner. The partnership does have a tax return where revenues and expenses are reported. The partnership generally does not pay taxes. Profits and losses are passed to the owners for reporting on their personal return via a Schedule K-1.
A corporation is an entity. The corporation is organized at the state level. You can organize in any state you choose. You will need a registered agent in the state you organize in if you do not have a physical presence in that state. (Many law firms and accounting offices offer this service registered agent services.)
An S-corp is organized as a regular corporation with an S-election made with the IRS. S-corporations generally do not pay taxes, but there are instances when the S-corp does owe tax, a complex issue not covered in this post. Much like a partnership, information from the S-corp is reported to owners on a K-1. S-corporations, while a powerful tax tool, have many complex issues buried within. A competent and qualified tax professional is suggested.
Then we come to the LLC, the most misunderstood animal in the small business world.
LLCs don’t pay taxes. LLCs don’t have a tax form. LLCs instead take on the flavor of whatever they touch.
Think of it this way:
- Individuals file taxes with Form 1040. The sole proprietor reports revenue and expenses for the small business by attaching a Schedule C to their personal tax return. That income (or loss) flows to the 1040.
- Partnerships file taxes on Form 1065, along with supporting forms and schedules.
- Corporations file their tax return on the Form 1120 series.
- S-corporations files taxes on the Form 1120-S series.
- LLCs file their taxes on, wait for it, one of the above mentioned bullet points!
- A single member LLC files as a sole proprietor. This is also known as a disregarded entity, where the LLC is disregarded for tax purposes only. Schedule C of the individual tax return is used.
- A multi-member LLC defaults to a partnership with the same rules as a partnership without an LLC. Again, this is a disregarded entity. A K-1 is issued to the owners for reporting on their personal tax return.
- An LLC can elect to be regarded! This means you inform the IRS you wish to be treated as a corporation for tax purposes. The election is made on Form 8832. Tax reporting is made on Form 1120.
- An LLC can elect to be an S-corporation. You do this by filing Form 2553 with the IRS. You can skip filing Form 8832 because the IRS knows that is you elect to treat your LLC as an S-corp you are also electing to be a corp that can make an S-election. Tax reporting is done on Form 1120-S.
Whatever structure you use for your LLC, the same tax rules apply as if there were no LLC. Restated, an LLC electing to be treated as an S-corp must follow the rules of an S-corp.
The LLC has a unique advantage over organizing as a corporation. The corporation can elect to be treated as an S-corp. The LLC, however, can elect to be a corporation, S-corp, partnership or sole proprietor. The LLC can also change its mind. For example, the LLC can start as a sole proprietorship (disregarded entity). As the business grows the LLC can elect to be treated as an S-corp. As the owner approached retirement, the the owner may cut back to where the S-corp provides little or no tax advantage. The LLC in such a situation can elect to be a sole proprietorship agan.
One note on the fluidity of the LLC. An LLC can elect to be an S-corp at any time. But if the LLC elects to terminate the S-election the LLC must wait 5 years before re-electing to be an S-corp.
Legal Differences Between the LLC and S-Corp
Corporations, including S-corporations, and LLCs are organized on the state level. Laws can vary among states. For example, certain professionals cannot organize as an LLC in California. Instead, they organize as a professional corporation (P.C.).
The LLC and corporation, including the S-corp, are legal entities that are designed to limit liability. It is important to consult with a competent and qualified attorney in the state you plan to organize to understand the limits of the liability protection.
My goal is to always make things understandable for people outside the accounting profession. I have run my understanding of the definition of the liability protections illustrated below past attorneys. They have all agreed that I have the basic idea of the legal difference between the LLC and S-corporate structures. Regardless, alway consult the attorney.
My simple explanation on the legal differences between the S-corp (not an LLC electing as such) and LLC (including an LLC electing as an S-corp) is as follows:
Owners of an S-corp (not an LLC electing as such) are liable for “all-acts”. LLC owners are liable for “own-acts”.
The easiest way to understand own-acts and all-acts is with either a law firm, accounting firm or medical practice. We’ll use the medical practice.
Suppose 20 doctors get together and open a medical clinic. If they organize as a partnership, corporation or S-corporation without an LLC, each doctor is liable for the acts of all the doctors in the group. One doctor gets sued, all get sued (are liable). “All-acts.”
If the same group of doctors organizes as an LLC, regardless if they conduct business as a partnership, corporation or S-corporation, if one doctor gets sued, one doctor gets sued. The other doctors are shielded by the LLC from acts of the other doctors. “Own-acts.”
If you are a single-member LLC own-acts are all-acts. From a liability standpoint there is less difference. But! the ability to change the way the entity is taxed can change. And that is a massive benefit!
Of course there are many additional legal issues surrounding LLCs and corporation.
Note: Just because you have a corporation or LLC does not absolve you of all liability risk. You still need adequate and appropriate insurance. The attorney is vital to assure the LLC or corporate documents are in order. Your attorney can help you understand the liability protections as they apply to you and your situation. The attorney is your friend.
When to Elect as an S-Corp
Up to this point the rules for an LLC and S-corporation are fairly static. The forms you use for tax reporting are clear. Legal issues are generally consistent among the 50 states with differences an attorney can clarify on issues specific to you.
But figuring out all the nuances in deciding when to elect to be an S-corp is more art than science when it comes to taxes. I like the S-corp structure for small businesses. But it does come with issues.
The main reason small businesses want to be treated as an S-corp is that all profits flow to the owners outside the payroll tax. However, current tax law throws a lot of moving parts into the equation. For example, the Qualifies Business Income Deduction (QBID) is affected. Full S-corp tax benefits are often muted by this one simple issue.
Facts and circumstances prevail. I can’t cover every possibility so you need a deep review of your situation before making a decision. Remember, you can undo the LLC election to be treated as an S-corp, but then you have to wait 5 years if you want to go back to an S-corp. A good decision in the beginning is important.
Let’s look at two massive issues with S-corporations before continuing:
1.) Basis A simple way to understand basis is with a piece of income property. Basis in such a case is the purchase price, plus improvements, minus depreciation.
Basis becomes more involved with a business. C-corp basis is simply the purchase price of the stock. Easy to understand and calculate.
Basis with an S-corp gets messy fast. Basis for the S-corp starts with your investment. Call it a contribution or your purchase price for the shares (straight S-corp) or membership interest (LLC).
But S-corp basis (regardless if you started as a corp or LLC) has unique rules. Some is very easy to understand. If you, as the owner, invest more money in the company your basis increases. Profits and losses add or subtract from your basis. Distributions come from basis and thereby lower it. It is easy to understand that a positive basis is good because it means you can potentially received money from the entity.
Then we come to debt. If the S-corp gets a loan for machinery, working capital, or any other reason, the debt may or may not add to basis. More to the point, S-corp basis for debt only increases for the owner the S-corp borrows from. (Read that a few times until it sinks in.) Even if the owner of an S-corp guarantees a bank loan to an S-corp it will not add to their basis¹.
With a few moments of thought it becomes easy to see how you could run out of basis. Taking a distribution after you run out of basis, a real possibility when the S-corp has a loan that does not contribute to basis, is a tax problem. To the point, distributions in excess of basis is taxed as a long-term capital gain. And remember, you already paid tax on the gain because gains flow through to the owner’s personal tax return on Schedule K-1.
2.) Reasonable Compensation If you think about the tax benefits of an S-corp it doesn’t take long to realize you don’t want to take a paycheck from the company. Instead, you want all the profits to flow to you on the K-1 where you don’t pay any payroll taxes.
But the IRS knows that trick!
S-corporations are required to pay “reasonable compensation” to owners before non-wage distributions. Some owners (in a multi-owner S-corp) may not get a paycheck because they are not involved in any aspect of the business. But at least one owner is doing something to manage that firm and that owner had better get a paycheck. The tax return clearly asks for wages to owners and non-owners. If you report no, or only a small amount of, owners wages on the tax return your audit risk heightens. The IRS could even terminate your S-election.
“Reasonable compensation” is a wide road not clearly defined by the tax code, regulations or the Tax Court. (There is no mechanical formula.) Many factors play into reasonable compensation: experience (doctors get paid more than plumbers (usually)), time spent at the activity, and even things like profit level.
Reasonable compensation is not an easy number. You certainly do not want your wage to push the S-corp into a loss because that will undo the major tax benefit of avoiding the payroll tax and push it into reverse, increasing your tax over not being an S-corp. If reasonable compensation would cause the business to show a loss, better to stay a disregarded entity.
So where do we go for reasonable compensation guidelines? Some tax professionals like to use 60% of profits as a guideline for the owner’s W-2 wage. This is not a hard and fast rule, only a guideline used by some accountants. The IRS may disagree. So do I.
When it comes to owner’s compensation in an S-corp, facts and circumstances prevail. You can start with a salary guide for the work the owner is performing. But even this can provide a wide range or inaccurate reasonable compensation. Adjustments need to be made reflecting differences between your position in the S-corp and that of the salary guide.
I don’t want to unduly concern readers over reasonable compensation, only to clarify that S-corp owners should not be seduced into taking an extremely low wage in an attempt to game the tax code. In my office I review owner’s compensation in every S-corp every year. Most years only a tweak is needed. Other years require very large change. “Facts and circumstances”, always facts and circumstances..
Now we can talk intelligently about when it might be a good idea to elect as an S-corp. Real estate never has a place in an S-corp! More on this in the closing section of this article.
For small businesses, I personally think a consistent profit is required before considering the S-election for an LLC. Not only do I want to see a profit, but need to be reasonably certain the profit will be consistent or climbing. All the advantage of the S-corp goes out the window if a one-year profit is followed by years of very low profits or even a loss.
So how much consistent profit does an LLC need before considering the S-corp route²? Anything under $50,000 is certainly questionable. I know some facts and circumstances may allow a break below this level and that taxes are not the only consideration, but if the goal is tax reduction, a low profit is not your friend when considering the S-corp.
There are more considerations than just taxes, too. Management of the company, industry and legal issues are examples. In no circumstance would I ever consider the S-corp for a business with losses or profits below $30,000.
Many tax professionals prefer $80,000 or more in profits before electing to treat an LLC as an S-corp. Running a business as a sole proprietorship with $75,000 of profits will be rather painful on April 15th so I start planning with clients before this point where possible.
There are additional costs to having an S-corp over a disregarded entity. Owners now get a W-2 wage. Single-member LLCs without employees will now have all the employment reports to file because the owner gets a wage versus a draw only.
If the LLC has a single member there will also be another tax return to file that almost certainly will cost more for a professional to prepare than the Schedule C on the personal return.
As you can see, there are a lot of considerations before electing to treat your LLC as an S-corp. The consequences are significant so adequate preparation is required. Professional help is recommended.
S-Corp Dos and Don’ts
I want to mention a few dos and don’ts before we close our discussion on S-corps.
As mentioned above, NEVER put real estate in an S-corp! It is not illegal, but is a really bad idea for two big reasons:
1.) Basis Yes, basis again. Real estate, with the exception of land, gets depreciated. Depreciation throws off your basis compared to the cash in the checkbook because depreciation is a non-cash deduction. In some instances this could reduce your ability to issue a distribution or trigger long-term capital gains taxes on the amount of distribution in excess of basis.
Of course, you can always have the bank issue the loan to you so you can lend the money to the S-corp. Good luck with that. Banks don’t want to do it and don’t care about your tax consequences. And don’t think about the S-corp guaranteeing a bank loan made to you and lent to the S-corp. It doesn’t work.
2.) Moving Real Estate Outside an S-Corp This issue is worse than #1. If at some point you decide to move real estate outside of your S-corp you trigger a taxable event. Let me state this more forcefully. If you decide to close your S-corp or the IRS terminates your S-election or you want to start gifting some of the real estate to the kids or. . . a taxable event is triggered!!! Real estate moved out of an S-corp is a deemed sale at fair-market value. Read that again about 30 times. You moved YOUR property from one hand to the next and owe tax without having actually sold the property. Now do you understand why real estate in an S-corp is a bad idea?
One last big don’t from the archive.
A new client had seven S-corps with real estate in each. He moved money between the S-corps without restraint as bills came in while another S-corp checking account had available funds.
Here is the problem in such a situation. First, the investment didn’t come from the owner, but from another S-corp. Who gets the basis?
Second, does the S-corp providing funds become an owner of the S-corp money is moved to? I don’t have a hard and fast answer, but let me illustrate the potential disaster.
An S-corp cannot have another S-corp as an owner. S-corps have other restrictions, too (example: no more than 100 owners). Moving money between S-corps is a basis nightmare to start! And a prohibited act!!!
You can argue if you like, but an S-corp receiving money from another S-corp will cause the termination of both S-corp elections when discovered by the IRS. And why wouldn’t the IRS want to terminate the S-elections in all the S-corps involved if real estate is held in said S-corps? Terminating the S-election moves the real estate outside the S-corp, triggering a deemed sale at fair-market value. A tax nightmare of epic proportions!
FTR, I disengaged the new client when I discovered the issues. It is a disaster in the making and life is too short to get in the middle of something that promises to be that messy. Another CPA with less S-corp experience picked up the ball where I left off and had no problem with S-corps trading money. I wish them well.
Do consider the S-corp, even with the complex rules involved. It is a powerful tool for a small business and some not so small businesses. There are rules to follow, for sure. Still, the LLC is a solid foundation for most small businesses and electing to treat your LLC as an S-corp can be a way to manage your tax liabilities as your profits grow. Done right, the S-corp is a wonderful gift to the small business owner. Done wrong, and, well, we don’t want to talk about it.
Be sure to share your ideas and experiences with having an LLC or LLC making the S-election in the comments section. Legal and tax professionals can add to what I’ve already presented. Small business owners can share their experience with these entities types.
¹ Of course experienced tax professionals will get into a discussion on debt basis. However, my goal here is to keep the explanation simple so new and small business owners get a basic understanding on how basis for an S-corp works. (Note that an S-corp owner receives basis when the owner, rather than the S-corp, makes a payment on a guaranteed loan to the S-corp.)
² Whenever I publish on when and when not to consider the S-corp route I get plenty of push-back from other tax professional. About 90% are in the same range as my opinion on the matter. That leaves room for 10% to take exception with my opinion. I encourage all tax professionals to comment below so readers (and other tax professionals) get a better idea of how other tax pros feels on the matter of reasonable comp.