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LLC vs. S Corporations

The primary reason people choose S Corporations rather than Limited Liability Companies is to save money on employment taxes. If you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You'll still be liable for self-employment taxes on the salary portion of your income, but you'll just pay ordinary income tax on the distribution portion. Depending on how you divide your income, you could save a substantial amount of self-employment taxes just by converting to an S-corporation.

However, it is important to note that the IRS tends to take a closer look at S-corporation returns since the potential for abuse is so large. For example, if you make $300,000 in one year but only designate $20,000 of that as salary income, you might trigger an IRS inquiry, since you are avoiding so much self-employment tax. The guiding principle is that you must designate a "reasonable" amount of your income as wages, rather than a distribution. What constitutes "reasonable" can often be a gray area, but if you push the envelope too far, you put yourself at risk for an IRS audit and potentially penalties and interest on any back taxes assessed by the IRS.

S Corporations must file an annual income tax return each year. The shareholders must maintain corporate formalities: bylaws, minutes, annual meetings...etc. S Corporations can only have U.S. citizens as shareholders and those shareholders must be individuals or certain trusts. There can only be one class of stock, with the profits & losses distributed based on the ownership % in the corporation.

In contrast, the owner of a single member LLC doesn't have to file a tax return for the LLC, as they only report the activity on their personal tax return. The operating agreement is much simpler. The red tape involved in forming an LLC isn't as stringent as that involved with S corps, which also leads to savings on accountant and attorney fees, among others. In addition, if the LLC has more than one member, the profits and losses can be divided however the members choose.

An LLC may elect to be taxed as an S Corporation. There are pros and cons to that scenario as well.

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