An S Corporation has strict rules regarding how profits are shared by the shareholders as the profits must be distributed according to the ratio of stock ownership even if the shareholders wish to distribute the profits differently. It is also important to note that each shareholder is taxed on their prorated share of S Corporation profits without regard to the actual amount of cash distributed. Alternatively, members of a LLC have much more flexibility and can usually distribute profits as they choose, subject to some tax requirements.
By way of example, let’s look at a situation where you and a partner form a LLC. Your partner contributed $80 of capital compared to your contribution of $20. However, your LLC Operating Agreement states profits are shared equally (50/50), because you perform 80% of the work compared to the 20% performed by your partner. A LLC can do that, but an S Corporation cannot.
Another major tax difference between an S Corporation and a LLC is that the earnings of the LLC (if it is a single member LLC or taxed as a partnership) are subject to self – employment tax. The IRS treats LLC members as self employed, therefore they are subject to the self-employment tax (13.3% for 2011) which is applied towards Social Security and Medicare benefits.
For an S Corporation shareholder, only the salary paid to them is subject to self-employment tax. The remaining income, the S Corporation profit, is not subject to the self – employment tax under the current tax law. As such, there is the potential to realize self – employment tax savings by using an S corporation.