Small Business Basics: How S Corps and LLCs Pay Taxes
Which business type is right for you?
Many small businesses are structured as limited liability companies (LLCs) or S corporations. If you are just starting into business and looking at business types, you may find the difference between an LLC and an S corporation confusing. The two business types are similar, but they do have some essential differences. We will look at the structure of the two business types, how the businesses report tax liability, and how the owners of these businesses pay taxes.
LLCs, S corporations and Pass-through Taxes
LLCs (classified for tax purposes as a sole proprietorship or a partnership) and S corporations are considered pass-through business entities. This means the taxes of the business are reported on the business tax return but are passed through to the individual owners. The owners receive a tax form that's included with the owner's tax return.
LLCs and Taxes
A limited liability company registers with a state but the LLC isn't recognized by the IRS as a tax entity. LLC owners are called "members." The IRS treats LLCs either as corporations, partnerships, or as part of the LLC owner's tax return (a "disregarded entity"). How an LLC pays federal income tax depends on how many owners it has:
- An LLC with one owner (called a Single-Member LLC) is considered a separate (disregarded) entity, and it pays taxes in the same way as a sole proprietor.
- An LLC with multiple members is considered by default to be taxed as a partnership.
S Corporations and Taxes
An S corporation (sometimes called a "Subchapter S corporation") is a special kind of corporation. Instead of the corporation paying federal income taxes, these taxes are passed through to the personal tax returns of the owners (shareholders).
Starting an LLC vs. Starting an S Corporation
An LLC is formed when it registers with a state, by filing Articles of Organization.
An S corporation doesn't register with a state. First, the business must register with a state by filing Articles of Incorporation. Then, the corporation may elect S corporation status by filing Form 2553 with the IRS.
An LLC may elect to be taxed as a corporation or as an S corporation. To do this, the business must file an election on Form 8832 by a specific date. Check with your tax professional to discuss the pros and cons of this election.
The form for electing S corporation status for an LLC is different from the form for electing S corporation status for a corporation (Form 2553).
Reporting Federal Income Taxes
Single-member LLC members pay income taxes on the net income of their business, through their personal tax return.
Multiple-member LLCs report total partnership taxes on IRS Form 1065 U.S. Return of Partnership Income. This form is an information return. The partnership doesn't pay tax on its income; the income is passed through to the individual partner (LLC member) tax returns.
S corporations report federal income taxes on IRS Form 1120-S. U.S. Income Tax Return for an S Corporation. The taxes are paid by the shareholders based on their share of the S corporation's taxable income.
Differences Between S Corporations and LLCs
Owner Tax Report Forms
- Single-Member LLC members report business income on Schedule C on their tax return.
- Multiple-Member LLC members report their share of business income on a Schedule K-1 (Form 1065)for partners
- S corporation shareholders report their share of business income on Schedule K-1 (Form 1120-S) for shareholders.
Information from the Schedule K-1 for each multiple-member LLC member and S corporation shareholder is included in Schedule E (Part II) of the owner's tax return.
- LLC members are considered to be self-employed, and they must pay self-employment tax (Social Security/Medicare tax) on their share of the profits of the business.
- S corporation shareholder income isn't self-employment income and it isn't subject to self-employment tax.
Total income for LLC members may include different kinds of income (dividends, for example) that are not considered self-employment income. The Schedule K-1 for these owners has a separate category for self-employment earnings (loss).
Qualified Business Income Deduction
LLC members and S corporation shareholders may be eligible for a qualified business income (QBi) deduction for tax years beginning in 2018. This deduction allows a deduction of up to 20% of their qualified business income, in addition to standard business deductions.
Limitations on Business Losses
Business owners who don't materially participate in their businesses may not be able to claim all losses on their tax returns. Owners of LLCs and S corporations are both subject to passive loss limitation rules.
The information contained here is for general purposes to help you understand the basics. It's not intended as tax or legal advice. Always consult your own CPA or attorney to discuss your specific business questions.