In order to truly understand the difference between limited liability companies ("LLCs") and corporations taxed pursuant to Subchapter S of the Internal Revenue Code ("S Corporations" or "S Corps"), it is important to realize that businesses exist within two different realms. The first realm is the state law realm which governs the interactions between the owners, the board of directors, the managers, and the like. The second is the realm of federal and state taxation, which have their own sets of guidelines that focus not on what the business can do, but the tax consequences of what the business does. The two sections below describe the similarities and differences between S Corps and LLCs for state law purposes and tax purposes.
State Law Considerations
Both LLCs and corporations are formed pursuant to state law. In South Carolina, that is accomplished by filing Articles of Organization (for LLCs) or Articles of Incorporation and Form CL-1 (for corporations) with the Secretary of State. In filing these documents, whether for an LLC or a corporation, you do not have to specify the tax classification of the entity (although corporations must, of course, be taxed as corporations).
For corporations, the Articles of Incorporation describe such things as whether or not the corporation will be a statutory close corporation, the number of authorized shares, and the company's registered office. For LLCs, the Articles of Organization describe similar things, but also whether the LLC will be member-managed or manager-managed. This topic is addressed in a prior blog entry.
Corporations and LLCs should also have other governance documents including bylaws (for corporations), an operating agreement (for LLCs), and minutes of various meetings addressing the organization of the company.
The federal tax laws and state tax laws are very similar with respect to their treatment of LLCs and corporations. I've ignored any distinction for now, but be aware that there may be some differences between state law taxation and federal law taxation.
Corporations are always taxed as corporations regardless of whether or not they are a statutory close corporation or not. A corporation that has not elected to be an S Corporation is called a C Corporation. A corporation may elect to be taxed pursuant to Subchapter S of the Internal Revenue Code, which generally provides for flow-through taxation such that the shareholders, rather than the corporation, will be taxed on the earnings of the company. Note that this flow-through taxation applies regardless of whether or not any distributions are made from the corporation. Distributions in order to satisfy the tax liability associated with flow-through income is often addressed in the corporate bylaws.
Becoming an S Corporation is often advantageous to small businesses because of the tax burdens associated with being a C Corporation. C Corporations are subject to a tax at the corporate level as well as a tax on dividends when they are distributed from the company. This is what is often referred to as double taxation of corporate earnings. There are several restrictions on S Corporations, particularly with respect to the type and number of shareholders (particularly, partnerships and other corporations cannot be shareholders), and so large corporations are often required to be C Corporations because of their large and diverse ownership structure.
LLCs are very flexible entitles. They may be taxed as disregarded entities, partnerships, C Corporations, or S Corporations. An LLC can "check the box" (by filing the proper IRS form) to be taxed as a corporation. Single-member LLCs that do not check the box to be taxed as a corporation are taxed as disregarded entities. Multi-member LLCs that do not check the box to be taxed as a corporation are taxed as partnerships. When (and if) an LLC checks the box to be taxed as a corporation, it may then further elect to be taxed as an S Corporation. If the LLC fails to elect to be taxed as an S Corporation, it is taxed as a C Corporation. Whether and how to properly elect tax classifications for LLCs are complex issues that should involve the assistance of a tax professional.
It is possible to legally reduce the burden of self-employment taxes through the proper use of S Corporation taxation (be it through a corporation or an LLC that has elected to be taxed as a corporation as described above). This, too, is a complex issue that should not be attempted without the assistance of tax professionals.