Case in point:

  • Mary owns a print shop. In keeping with the industry standard, Mary decides that a reasonable salary for a print shop manager is $35,000 and pays herself accordingly. Mary’s total earnings for the year are $60,000: $35,000 paid in salary and the remaining $25,000 paid as a distribution from the S corp. Mary’s total employment tax is $5,355 (15.3% of $35,000).


If Mary were the owner of an LLC, she would have to pay employment tax on the entire $60,000, equaling $9,180. But as an S corporation, she realizes savings of $3,825 in employment tax.


One might assume that these savings could be further manipulated by reducing the salary to an extremely low amount and attributing the rest of one’s earnings to distributions—but this would be an incorrect assumption. In practice, the IRS is careful to notice whether a salary is reasonable by industry standards. If it determines a salary to be unreasonable, the IRS will not hesitate to reclassify distributions as salary.

Still, while the potential employment tax savings may make the S corporation an attractive structure for your business, bear in mind that you would then have to deal with all the paperwork associated with payroll tax. The payroll tax is a pay-as-you-go tax that must be paid to the IRS regularly throughout the year--on time, or you will incur interest and penalties. The paperwork alone can be an overwhelming task for someone who is not familiar with this; and if you expect to incur losses or otherwise experience a cash flow crunch during the year that would hinder you from paying the payroll tax when due, this could present a problem.

Owners of LLCs pay their self-employment tax once a year on April 15 when income taxes are normally due. Income tax filings are also relatively easy for the owners of an LLC: A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor; partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.


LLC Advantages


A limited liability company (LLC) has many advantages as a form of business entity:


  • Pass-through taxation - under the default tax classification, profits taxed at the member level, not at the LLC level (i.e., no double taxation). 
  • Limited liability - the owners of the LLC, called "members," are protected from liability for acts and debts of the LLC.
  • With "check-the-box" taxation, an LLC can elect to be taxed as a sole proprietor, partnership, S-corp or corporation, providing much flexibility.
  • Can be set up with just one natural person involved or, in some states, one owner which may be an entity itself.
  • No requirement of an annual general meeting for shareholders (in some states, such as Tennessee and Minnesota, this statement is not correct).
  • No loss of power to a board of directors (although an operating agreement may provide for centralization of management power in a board or similar body).
  • LLCs are enduring legal business entities, with lives that extend beyond the illness or even death of their owners, thus avoiding problematic business termination or sole proprietor death.
  • Much less administrative paperwork and record keeping.
  • Membership interests of LLCs can be assigned, and the economic benefits of those interests can be separated and assigned, providing the assignee with the economic benefits of distributions of profits/losses (like a partnership), without transferring the title to the membership interest (e.g., see Virginia and Delaware LLC Acts).


LLC Disadvantages


While a limited liability company (LLC) offers many advantages over other forms of business entity, there are also some disadvantages. Some of the drawbacks to selecting an LLC over another entity are:


  • Earnings of most members of an LLC are generally subject to self-employment tax. By contrast, earnings of an S corporation, after paying a reasonable salary to the shareholders working in the business, can be passed through as distributions of profits and are not subject to self-employment taxes.
  • Since an LLC is considered a partnership for Federal income tax purposes, if 50% or more of the capital and profit interests are sold or exchanged within a 12-month period, the LLC will terminate for federal tax purposes.
  • If more than 35% of losses can be allocated to non-managers, the limited liability company may lose its ability to use the cash method of accounting.
  • A limited liability company which is treated as a partnership cannot take advantage of incentive stock options, engage in tax-free reorganizations, or issue Section 1244 stock.
  • There is a lack of uniformity among limited liability company statutes. Businesses that operate in more than one state may not receive consistent treatment.
  • In order to be treated as a partnership, an LLC must have at least two members. An S corporation can have one shareholder. Although all states allow single member LLCs, the business is not permitted to elect partnership classification for federal tax purposes. The business files Schedule C as a sole proprietor unless it elects to file as a corporation.
  • Some states do not tax partnerships but do tax limited liability companies.
  • Minority discounts for estate planning purposes may be lower in a limited liability company than a corporation. Since LLCs are easier to dissolve, there is greater access to the business assets. Some experts believe that limited liability company discounts may only be 15% compared to 25% to 40% for a closely-held corporation.
  • Conversion of an existing business to limited liability company status could result in tax recognition on appreciated assets.


Should Your LLC Elect to be Treated as an S Corp?


One of the more recent developments in the toolkit of planners structuring entities is the idea of forming an entity as a limited liability company (LLC) under state law and then making an election under Federal tax rules to have the entity taxed as a "small business corporation", more commonly called a "S Corporation" or "S corp." The main reason for making the S corp election is so that the part of the economic gain of the entity can be treated as the profit of the enterprise rather than wages. Unlike wages, S corp profits are not subject to self-employment taxes.


Is the S Corp Election a Good Idea?


There are pros and cons to consider if you are thinking about electing S corporation tax treatment for your LLC. One the one hand, you get the benefit of having only your wages subject to self employment taxes if the LLC is taxed as an S corporation. On the other hand, your LLC must also comply with all of the ownership rules applicable to S corporations. Those rules include the requirement of a single class of ownership, no non-resident alien members, and no corporations or partnerships as members. Also, as a separate entity, the S corp must comply with all the withholding and reporting requirements of an employer, a task that wasn't necessary if the LLC had no employees other than its members.

Another factor to remember is that not all states recognize the S election. The tax treatment under state law of an LLC electing S corporation tax status is going to vary from state to state and you should talk to a tax professional who is familiar with your state tax laws before making a final determination to have your LLC treated like an S corp.


Why Not Just Use a Corporation?


If you want your business to be taxed as an S corporation, why not just use a corporation rather than a limited liability company? The principal benefit of using an LLC rather than a corporation is that an LLC is a more flexible entity under state law. Even though you need to comply with the rules applicable to S corporations with respect to ownership, the LLC still offers much more room to design the entity to your own specifications. Using an LLC allows you to eliminate many of the formalities that a corporation must observe to preserve its corporate status. With an LLC, you do not need a board of directors, meetings or minutes , for example.


How Does an LLC Choose to be Taxed as an S Corporation?


To have your LLC receive the tax treatment of an S Corp, you must file an election with the IRS using Form 2553. You must file Form 2553 within the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. If you file it later, your election will be effective for the next tax year.

There has been some confusion in the process with some writers stating that the LLC must elect to be treated as a regular corporation under the IRS's check-the-box regulations, subsequently followed by Form 2553. That is not the case.


The Final Analysis


If you have a business that generates a nice profit over and above what you would consider reasonable compensation for the services that the owners provide, you may be unnecessarily subjecting the profits to self employment taxes if you are operating as an LLC taxed as a partnership. If you think your business may fit this model, your LLC may benefit from choosing to be treated as an S corporation under the tax laws. There are drawbacks, however, so no decision should be made without discussing your own situation with a qualified professional.


LLC vs C Corporation vs S Corporation


Entities CharacteristicsLLCC CorporationS Corporation
Ownership RulesUnlimited number of members allowed
Unlimited number of shareholders; no limit on stock classes
Up to 100 shareholders; only one class of stock allowed
Personal Liability of the Owners
Generally no personal liability of the members
Generally no personal liability of the shareholders
Generally no personal liability of the shareholders
Tax TreatmentThe entity is not taxed (unless chosen to be taxed); profits and losses are passed through to the members
Corporation taxed on its earnings at a corporate level and shareholders are taxed on any distributed dividends
With the filing of IRS Form 2553, a C Corporation becomes a S Corporation, where the profits and losses are passed through to the shareholders
Key Documents Needed for Formation       
Articles of Organization / Certificate of Formation; Operating Agreement
Articles of Incorporation; Bylaws; Organizational Board Resolutions; Stock Certificates; Stock Ledger
Articles of Incorporation; Bylaws; Organizational Board Resolutions; Stock Certificates; Stock Ledger; IRS & State S Corporation election
Management of the Business
The Operating Agreement sets forth how the business is to be managed; a Member (owner) or Manager can be designated to manage the business
Board of Directors has overall management responsibility; Officers have day-to-day responsibility
Board of Directors has overall management responsibility; Officers have day-to-day responsibility
Capital Contributions
The members typically contribute money or services to the LLC and receive an interest in profits and losses
Shareholders typically purchase stock in the corporation, either common or preferred
Shareholders typically purchase stock in the corporation, but only one class of stock is allowed



What is a Single Member LLC?


A single member LLC (SMLLC) is simply a limited liability company that has only one member. Under current IRS rules, unless the SMLLC elects to be treated as a corporation, it is disregarded for Federal income tax purposes. That means if the only member is an individual, all of the income and expenses of a business operated as a single member limited liability company will be reported on a Schedule C attached to the individual's Form 1040. If the single member is a corporation or partnership, the SMLLC's income and expenses will be aggregated with the other income and expenses of the corporation or partnership and reported on that entity's tax return.

When states originally enacted their LLC statutes, organizing a limited liability company typically required that there be two or more members. SMLLCs were not allowed. An individual wanting to form an LLC needed to add another person in order to take advantage of this newly-available entity.

Gradually states began to adopt amendments to their LLC acts that permitted limited liability companies with only one member. Even if your state allowed the formation of SMLLCs, however, there was a question whether states that still did not permit SMLLCs to be formed in their state would recognize SMLLCs formed in other states where they were permitted.

Fortunately, all 50 states and the District of Columbia now permit SMLLCs, so that issue is no longer a concern.

There is some lingering worry among legal analysts as to whether a member of SMLLC will be given the same protection from liability as a member of a limited liability company with multiple members. In most states, the statute appears clear, but it may take many years for case law to develop to the extent that some lawyers will have the comfort level that they have from decades of case law on one-shareholder corporations. In the end, it seems probable that a member of a SMLLC will have no less protection than a sole shareholder of a corporation. (There is one circumstance, however, where a multiple member LLC holds a distinct advantage over a SMLLC — protecting the assets of the LLC from the creditors of the member - with respect to charging orders against the LLC by the creditors of the member. See Single Member LLC or Multiple Member LLC?.)

There are some differences between SMLLCs and other LLCs, and a member of the LLC should be aware of them. For example, in Illinois, the operating agreement of a manager-managed single member limited liability company must be in writing if the manager is the same person as the member.

In some cases, a business owner forming a new limited liability company as a single member LLC (SMLLC) may raise a question as to whether there is a advantage or disadvantage to adding another person (perhaps a spouse of the member) simply to cause the LLC to become a multiple member LLC.

In the 1990's as many states were enacting LLC statutes for the first time, many states did not permit SMLLCs at all. If you were in a state that did not allow the formation of LLCs with only one owner, the issue was clear: you needed to add another person in order to take advantage of this newly-available entity. Even if your state allowed the formation of SMLLCs, however, there was a question whether states that did not permit SMLLCs to be formed in their state would recognize SMLLCs formed in other states where they were permitted. Fortunately, all 50 states and the District of Columbia now permit SMLLCs, so that issue is no longer a threat.

There is some lingering concern among legal writers as to whether a member of SMLLC will be given the same protection from liability as a member of a limited liability company with multiple members. In most states, the statute seems clear, but it will take many years for case law to develop that will give some lawyers the comfort that comes from decades of case law on single shareholder corporations. In the end, it seems likely that a member of a SMLLC will have no less protection than a sole shareholder of a corporation.

There is one circumstance, however, where a multiple member LLC holds a distinct advantage over a SMLLC — protecting the assets of the LLC from the creditors of the member. Generally, a creditor of a member of an LLC can only seek what is known as as charging order against the member's membership interest in the LLC. The creditor cannot directly attach the assets of the LLC but may only receive payments out of the member's distributional interest. However, there is a question as to whether a single-member limited liability company will be effective for protection against a creditor of the sole member.


Single Member LLC or Multiple Member LLC?


In some cases, a business owner forming a new limited liability company as a single member LLC (SMLLC) may raise a question as to whether there is a advantage or disadvantage to adding another person (perhaps a spouse of the member) simply to cause the LLC to become a multiple member LLC.

In the 1990's as many states were enacting LLC statutes for the first time, many states did not permit SMLLCs at all. If you were in a state that did not allow the formation of LLCs with only one owner, the issue was clear: you needed to add another person in order to take advantage of this newly-available entity. Even if your state allowed the formation of SMLLCs, however, there was a question whether states that did not permit SMLLCs to be formed in their state would recognize SMLLCs formed in other states where they were permitted. Fortunately, all 50 states and the District of Columbia now permit SMLLCs, so that issue is no longer a threat.

There is some lingering concern among legal writers as to whether a member of SMLLC will be given the same protection from liability as a member of a limited liability company with multiple members. In most states, the statute seems clear, but it will take many years for case law to develop that will give some lawyers the comfort that comes from decades of case law on single shareholder corporations. In the end, it seems likely that a member of a SMLLC will have no less protection than a sole shareholder of a corporation.

There is one circumstance, however, where a multiple member LLC holds a distinct advantage over a SMLLC — protecting the assets of the LLC from the creditors of the member. Generally, a creditor of a member of an LLC can only seek what is known as as charging order against the member's membership interest in the LLC. The creditor cannot directly attach the assets of the LLC but may only receive payments out of the member's distributional interest. However, there is a question as to whether a single-member limited liability company will be effective for protection against a creditor of the sole member.

In a Colorado bankruptcy case, a debtor who filed a Chapter 13 petition that was later converted to the Chapter 7 liquidation was the sole member and manager of a Colorado LLC at the time of the bankruptcy filing. The LLC was not a debtor in bankruptcy. The Chapter 7 trustee argued that because the debtor was the sole member and manager at the time the debtor filed his bankruptcy petition, the trustee now controlled the LLC and could therefore sell the real property owned by the LLC and distribute the net sales proceeds to the bankruptcy estate. The debtor argued that trustee was only entitled to a charging order. The court ruled that because there were no other members of the LLC, the entire membership interest passed to the bankruptcy estate and the trustee became a "substituted member". The court concluded that because there were no other members of the LLC, no written unanimous approval to transfer was necessary, as would otherwise be required under Colorado law if there were other members.


Disadvantages of a Multiple Member LLC over a SMLLC


The principal disadvantage of a multiple member LLC is that it must file a partnership tax return and comply with the sometimes complex rules of partnership taxation. A SMLLC, on the other hand, is disregarded for Federal (and most state) tax purposes. The member of an SMLLC simply reports the income and expenses of the LLC on his or her own Form 1040 on Schedule C.

In addition to the complexity of partnership taxes and the need to file an extra return, in several states (Illinois is one), there are income taxes imposed on partnerships that are not imposed on individuals.


How Limited is Limited Liability?


One of the key advantages of a limited liability company (LLC) over a sole proprietorship or general partnership is the fact that the owners (members) of the LLC are not personally liable for the debts and claims of the business. Normally, that means that if the business is unable to pay a supplier, lender, landlord or other creditor, that person cannot go after the personal assets of the members of the LLC. The members may lose their entire investment in the business, but their other assets - car, home, and personal bank accounts - are safe from the creditors of the business.

Or are they? In truth, there are many exceptions to the rule of limited liability. Many LLC members will find that, due to the way the business was operated, the promised protection from the liabilities and claims of the business is not meaningful.


How Personal Liability Arises


A member of an LLC can be held personally liable for many different types of claims, but they typically arise under four different scenarios:

  • Claims arising out of an act or omission by the member, such as the member's own negligence, fraud or illegal act.
  • Claims arising out of a contract, particularly one that was personally guaranteed by the member.
  • Claims based on the concept of "piercing the veil" of the LLC.
  • ​Liability for consenting to or receiving a distribution in violation of the LLC's operating agreement or the applicable LLC statute


These claims are not a result of choosing an LLC as a form of entity. All of these exceptions apply equally to shareholders in corporations and, in fact, the exceptions were developed first under corporate law.


Actions of a Member


Every member who actively participates in the business of the LLC runs the risk that his action or inaction will result in personal liability. This is particularly a risk of a service business in which the members provide the key service. If you are an electrician and you leave an exposed wire that electrocutes someone, your LLC is not going to protect you.

Similarly, if you make promises about your product or service that are not true, the first claim may be against the LLC for breach of contract, but if the LLC cannot perform or pay damages, the injured party may come after you for fraud or a similar claim based upon your own action.

Even if you have an employee who committed the action, you may not be out of the woods. If you personally hired the employee, the injured party may have a claim against you for negligent hiring if a reasonable person would not have hired that employee.

A special category of personal liability that may trip up a member of an LLC is failure to pay payroll taxes to the IRS. To protect these so-called "trust fund taxes," any person who had the ability to prevent the non-payment can be personally liable for the failure to pay these taxes. The IRS applies this provision broadly, so if you had power to direct which bills got paid and which didn't, you are probably liable.


Claims Based on Contract


Another, and probably more common, source of personal liability for many small business owners is the voluntary assumption of liability, usually by means of a personal guarantee. For many small businesses, particularly new businesses with no credit history, obtaining a loan without a personal guarantee is virtually impossible. Landlords, too, often insist on a personal guarantee, particularly if the lease requires the landlord to incur costs such as build-outs that it expects to recoup over the term of the lease.

Suppliers are sometimes more flexible on extending credit, especially after the business is up and running. Getting payment terms out of the gate, however, often requires a personal guarantee.

Even when the creditor isn't seeking a personal guarantee, a member of the LLC can inadvertently become a party to the contract by failing to clearly note his role. If she signs her own name and does not indicate that she is executing the contract on behalf of the LLC, it is very likely that a court will hold her responsible for the contract. Every contract should clearly indicate that the party to the contract is the LLC (full name!) and should indicate the role of the person who is signing (member or manager).


Piercing the Veil of the LLC


Even if a member avoids personal guarantees, he may find himself liable to creditors of the business under a theory developed under corporate law and known as "piercing the corporate veil." Although the factors that courts look at vary to some extent from jurisdiction to jurisdiction, the courts typically look at whether there is a unity of interest and ownership such that the separate personalities of the entity and the owner no longer exists and whether to respect the distinction between the owner and the entity would be an injustice.

In almost all cases of piercing the veil, there is either commingling or diversion of assets. Some other facts that courts examine in corporate cases include:

  • ​Inadequate capitalization
  • Failure to issue stock
  • Failure to observe corporate formalities
  • Nonpayment of dividends
  • Insolvency of the debtor corporation at the time
  • Non-functioning of other officers or directors
  • Absence of corporate records
  • Commingling of funds
  • Diversion of assets
  • Failure to maintain arm's length relationships among related entities
  • Whether the corporation is a mere facade for the operation of the dominant shareholders


A possible benefit of an LLC over a corporation is that several of the commonly listed factors (failure to issue stock, failure to observe corporate formalities, and absence of corporate records) have no real counterparts in an LLC. However, as case law develops, the absence of those factors may simply shift emphasis on some of the other factors.


Distributions in Violation of Law or Agreement


LLC Acts typically prohibit an LLC from making certain distributions. For example, the final draft of the Revised Uniform Limited Liability Company Act provides that a limited liability company may not make a distribution if after the distribution: (1) the company would not be able to pay its debts as they become due in the ordinary course of the limited liability company’s activities; or (2) the company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the company were to be dissolved, wound up, and terminated at the time of the distribution, to satisfy the preferential rights upon dissolution, winding up, and termination of members whose preferential rights are superior to those of persons receiving the distribution.

A member of a member-managed limited liability company or manager of a manager-managed limited liability company who consents to an improper distribution is personally liable to the company for the amount of the distribution which is improper distributions. In addition, a person who receives a distribution knowing that it is in violation of the Act is typically personally liable for the portion of the distribution that is improper.


Is Limited Liability an Illusion?


Although it may seem that the exceptions swallow the rule, the LLC offers excellent protection from many types of liabilities. For example if you properly hire and train an employee who then commits an act of negligence or fraud, the LLC should shield you from personal liability. If you sell a product that, without your knowledge or fault, is defective, you should not have personal liability. Trade creditors who deal with the LLC without a personal guarantee should have no right to look to you for payment.


Shoring up Limited Liability


There are several things that you can do to strengthen the protection of limited liability within the LLC:

  • Business insurance- Carrying adequate business insurance won't change the fact that you are personally liable for your own negligence, but it can help by providing a source for payment. You might also consider a personal umbrella policy.

  • Avoid personal guarantees- Not all personal guarantees can be avoided but do not automatically consent to every guarantee. In many cases, landlords or vendors routinely request personal guarantees even where the facts do not dictate that one be provided. Learn to question the request.
  • Capitalize the business adequately-  Provide adequate capital for the entity's intended purposes and document the capital infusion.
  • Keep the LLC separate from your personal business- No matter how small the business is, it should have its own bank account. Don't pay personal expenses from the business account. Instead, write yourself a check (called a draw) on the LLC account and deposit it in your account from which you pay expenses. Likewise, don't use personal checks to pay LLC bills. If the LLC needs funds, make a capital contribution or loan. And account for everything.
  • Act ethically- Don't attempt to mislead the LLC's creditors about the financial condition of the business.
  • Do not divert assets- If the business looks like it is going down, don't attempt to lessen your own loss by taking big draws or moving assets out of the LLC. That will only help open the floodgates to your personal assets.


If you act responsibly and take a few precautions, the limited liability of the LLC is still a major benefit over a sole proprietorship or general partnership

A major factor that differentiates an S corporation from an LLC is the employment tax that is paid on earnings. The owner of an LLC is considered to be self-employed and, as such, must pay a “self-employment tax” of 15.3% which goes toward social security and Medicare. The entire net income of the business is subject to self-employment tax.*


In an S corporation, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules. Therefore, there is the potential to realize substantial employment tax savings. 

When beginning a business, you must decide what form of business entity to establish. Your form of business determines which income tax return form you have to file. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute. Legal and tax considerations enter into selecting a business structure. This page covers LLC vs S Corporation and C corporation. Please see the small business tab for information about other types of business entities.


LLC vs S Corporation


In researching the various business structures, one inevitably comes across the S corporation. S corps and limited liability companies (LLCs) are similar in that they are both "pass-through" entities for tax purposes; the income of these companies are passed through to their owners and reported on the owners’ personal income tax returns, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation. (With a C corporation, the net business income is subject to corporate income tax, and the monies remaining after the corporate income tax are taxed a second time when they are distributed as dividends to its owners who must then pay personal income tax.)


So what is the difference between an S corporation and an LLC? And which structure is right for you?

The answer depends on your own unique situation. If operational ease and flexibility are important to you, an LLC is a good choice. If you are looking to save on employment tax and your situation warrants it, an S corporation could work for you.


Business Ownership & Operation


There are restrictions on who can be owners (called "shareholders") of an S corporation. An S corporation can have no more than 75 shareholders. None of the shareholders can be nonresident aliens. And shareholders cannot be other corporations or LLCs.

An S corporation is operated in the same way as a traditional C corp. An S corp. must follow the same formalities and record keeping procedures. The directors or officers of an S corp. manage the company. And an S corp has no flexibility in how profits are split up among its owners. The profits must be distributed according to the ratio of stock ownership, even if the owners may otherwise feel it is more equitable to distribute the profits differently.

LLCs offer greater flexibility in ownership and ease of operation. There are no restrictions on the ownership of an LLC. An LLC is simpler to operate because it is not subject to the formalities by which S corps must abide. An LLC can be member-managed, meaning that the owners run the company; or it can be manager-managed, with responsibility delegated to managers who may or may not be owners in the LLC.

And the owners of an LLC can distribute profits in the manner they see fit.

Let’s say, for example, you and a partner own an LLC. Your partner contributed $40,000 for capital. You only contributed $10,000 but you perform 90% of the work. The two of you decide that, in the interest of fairness, you will each share the profits 50/50. As an LLC you could do that; with an S corporation, however, you could only take 20% of the profits while your partner would take the other 80%.


Employment Tax: Savings vs. Paperwork

LLC vs S Corporation

MIARI TAX & ACCOUNTING