Limited liability companies, or LLCs, are becoming more and more popular, and it's easy to see why. They combine the personal liability protection of a corporation with the tax benefits and simplicity of a partnership. In other words, the owners (or "members") of an LLC are not personally liable for its debts and liabilities, but also have the benefit of being taxed only once on their profits. Moreover, LLCs are more flexible and require less ongoing paperwork than an S-Corporation.

To avoid double taxation, corporations can make a special tax election, known as a "subchapter S election", to be taxed as a flow-through entity like a partnership and LLC. Corporations which make the subchapter S election are known as "S-corporations", and corporations which do not are known as "C-corporations." However, there are still important differences between S-corporations and LLCs.

Advantages:

There are fewer corporate formalities for LLC's:
Corporations must hold regular meetings of the board of directors and shareholders, keep written corporate minutes and file annual reports with the state. Members and managers of an LLC need not hold regular meetings, which reduces complications and paperwork.

No ownership restrictions:
S-corporations cannot have more than 75 stockholders, and each stockholder must be a natural person who is a resident or citizen of the United States. There are no such restrictions placed on an LLC.

Ability to use the cash method of accounting:
Unlike a C-corporation, which often must use the accrual method of accounting, most limited liability companies can use the cash method of accounting. This means that income is not earned until it is received.

Ability to place membership interests in a living trust:
Members of an LLC are free to place their membership interests in a living trust. It is difficult to place shares of an S-corporation into a living trust.

Ability to deduct losses:
Members who are active participants in the business of an LLC are able to deduct its operating losses against the member's regular income to the extent permitted by law. Shareholders of an S-corporation are also able to deduct operating losses, but shareholders of a C-corporation are not.

Unemployment tax:
A member-employee of an LLC is not required to pay unemployment insurance taxes on his or her salary. Shareholder-employees of corporations must pay this tax. Currently, the federal unemployment tax is 6.2% of the first $7,000 of wages paid, to a maximum of $434 per employee.

Disadvantages:

Profits are subject to social security and medicare taxes:
In some circumstances, owner-employees of an LLC may end up paying more taxes than owner-employees of a corporation. Salaries and profits of an LLC are subject to self-employment taxes, currently equal to a combined 15.3%. With a corporation, only salaries (and not profits) are subject to such taxes. This disadvantage is most significant for member-employees who take a salary of less than $72,600.

Example:
Assume a member earns $30,000 in salary and is distributed $20,000 of the LLC's profits, a 15.3% tax would have to be paid on $50,000. For an S-corporation, social security and medicare taxes would only have to be paid on the $30,000 salary.

Owners must immediately recognize profits:
A C-corporation does not have to immediately distribute its profits to its shareholders as a dividend. This means that shareholders in a C-corporation are not always taxed on the corporation's profits. Because an LLC is not subject to double-taxation, the profits of the LLC are automatically included in a member's income.

Fewer tax exempt fringe benefits:
Member-employees of an LLC who receive fringe benefits, such as group insurance, medical reimbursement plans, medical insurance and parking, must treat these benefits as taxable income. The same is true for stockholder-employees who own more than 2% of an S-corporation. However, stockholder-employees of a C-corporation who receive fringe benefits do not have to report these benefits as taxable income.

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