Massachusetts LLC Vs. S Corp

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The commonwealth of Massachusetts treats a limited liability company (LLC) as a pass-through entity, meaning that the income of an LLC flows through to the member owners. The Massachusetts Department of Revenue (DOR) taxes a member owner for their share of the profit of the business.

In contrast, an S corporation (S Corp) is an accounting entity. An accounting entity is a business for which a separate set of records are maintained. Here separate means separate from the owners. An S Corp is an accounting entity because it determines its income as a corporation. The DOR recognizes an S Corp and taxes it as a corporation. Which structure is better for a business depends on the goals of that business.

Flexibility Vs. Rigidity

The most significant difference between an LLC and an S Corp is that an S corp is more rigid and formal. It is a type of corporation and so must abide by legal norms such as creating and keeping the minutes of company meetings. An S Corp is required to have a board of directors.

An LLC has member owners. There is no limit to the number of member owners an LLC can have. An LLC can also designate a member owner, nonmember or another party to lead the company. An S Corp has the typical officers one would usually find in a corporation, such as a president and vice-president.

An S Corp offers more of a sense of permanence and continuity. This is because an S Corp continues to exist after an officer leaves, whereas an LLC can be dissolved if a member owner departs.

Best Choice for Small Business Corporation

Typically, an LLC is a better choice for a small business than is an S Corp. This is because a small business is likely to find corporate formalities like adopting bylaws and holding annual shareholder meetings to be burdensome. An LLC must follow some norms, such as issuing membership shares and documenting all major company decisions, but these requirements are less strict than those for a corporation.

Personal Liability Protection for Owners

Both an LLC and an S Corp are organized to provide a greater amount of liability protection to owners than a sole proprietorship or a partnership. Each passes through income to owners to avoid corporate taxation. Both are organized under the Massachusetts Secretary of the Commonwealth.

Features of an LLC

An LLC is an unincorporated association with member owners. The purpose of the association is to shield the member owners to a limited extent from debts, obligations and liabilities. A member owner can help manage and control the LLC without becoming personally liable for the debts of the business. An LLC is required to file an annual report with the Secretary of the Commonwealth.

An LLC is distinguished from a limited liability partnership (LLP) in that an LLP files as a partnership. It, too, is a pass-through entity for tax purposes, in which member owners report earnings on their personal income tax forms. Yet an LLP’s business structure, for management purposes, is governed by the partnership agreement rather than by an operating agreement.

Formation of an LLC

Forming an LLC requires all of these actions:

  • Filing a certificate of organization with the Secretary of the Commonwealth.
  • Paying a $500 filing fee to the Secretary of the Commonwealth.
  • Naming the LLC.
  • Choosing a registered agent.
  • Creating an operating agreement, which is similar to a partnership agreement.
  • Registering with the IRS.
  • Registering with DOR.
  • Registering with the Massachusetts Division of Unemployment Assistance.
  • Getting an employer identification number (EIN).

Features of an S Corporation

An S Corp is a for-profit corporation that elects to be taxed under Subchapter S of the Internal Revenue Code. This makes the business entity a pass-through entity for tax purposes. The owners report the company’s revenue as personal income.

An S Corp is incorporated under the same state corporation laws as a C corporation (C Corp). The primary difference from an S Corp is that a C Corp pays taxes on its business income. Its shareholders also pay federal income taxes on their dividends. In this way, a C Corp incurs double taxation.

Formation of an S Corporation

Business owners create an S Corp by taking all of these actions:

  • Filing articles of incorporation with the Secretary of the Commonwealth.
  • Paying $275 filing fee for up to 275,000 shares and $100 for each additional 100,000 shares or portion thereof.
  • Naming the S Corp.
  • Choosing a registered agent.
  • Creating an operating agreement.
  • Registering with DOR.
  • Registering with the Massachusetts Division of Unemployment Assistance.
  • Getting an employer identification number (EIN).
  • Completing IRS Form 2553.

An S Corp organized in Massachusetts is a domestic corporation. An S Corp that is organized or chartered in another state or country is a foreign corporation. There are different fees and rules for foreign corporations.

For example, a foreign S Corp must file a foreign registration certificate with the Secretary of the Commonwealth within 10 days of beginning business in Massachusetts. All S Corps must file an annual report with Commonwealth within two and a half months after the end of its fiscal year.

Limitations of S Corps

There are a number of limits on an S Corp, as opposed to a C Corp. For example, an S Corp:

  • Must have 100 or fewer shareholders.
  • May not have C Corps as shareholders.
  • Is required to issue only one class of stock, with all members having the same distribution amount.

In Massachusetts, the Secretary of the Commonwealth provides that certain entities may be shareholders of an S Corp:

  • Individuals.
  • Certain exempt organizations.
  • Estates.
  • Certain trusts.
  • U.S. citizens or resident aliens.

An S Corp may own shares in another S Corp in specific situations. The subsidiary must be a qualified subchapter S Corp (QSUB). Certain taxpayers may not own shares in an S Corp. They include:

  • C Corps.
  • Partnerships.
  • Nonresident aliens.
  • Foreign trusts.
  • Multiple member LLCs.
  • LLPs.
  • Individual retirement accounts (IRAs).

Differences Federal and State Laws for S Corps

A business entity that is an S Corp for federal purposes is an S Corp according to the state of Massachusetts, with the exception of a security corporation. A security corporation is a company that holds securities, like debt instruments and options.

How an LLC Is Taxed

Massachusetts disregards a single-member LLC as an entity separate from its owner for Massachusetts income tax purposes if the LLC is disregarded for federal tax purposes. An LLC with two or more members is treated as a partnership if the company is treated as a partnership for federal tax purposes.

An LLC is treated as a corporation for Massachusetts income tax purposes if it is classified this way for federal tax purposes. Members of an LLC pay self-employment taxes on their portion of the LLC’s profits.

Member owners can determine their portion of the tax by following the terms of the operating agreement. Typically, member owners’ distributions are proportionate to their percentage interest in the business. For example, if a member owner owns 70 percent of the LLC, they will be entitled to 70 percent of the LLC’s profits and charged with 70 percent of its losses.

Taxation of Special Allocations and Distributive Shares

When member owners want to divide profits and losses in a manner that is not proportionate to their percentage interests in the business, this is called a special allocation. The Internal Revenue Service (IRS) has rules regarding such divisions. It treats member owners as if they received their whole distribution each year.

An LLC member owner is required to pay taxes on their whole distributive share, even if the LLC did not actually distribute all of that money to them. An LLC that wants to keep a significant amount of profits, called retained earnings, can elect corporate taxation.

The LLC should file IRS Form 8832 and check the box for corporate tax treatment. Member owners who want the LLC to regularly keep its earnings but still keep the pass-through tax structure can elect that the business be treated as an S Corp.

Filing of LLC Tax Returns

The LLC does not have to file a tax return, but LLCs with two or more members are required to file Form 1065 with the IRS. This is an informational return that shows the IRS that member owners are reporting their income correctly. Each member owner must also report their share of profit and losses on their Form 1040. The LLC issues a Schedule K-1 to each member owner to show their share of profits and losses.

How an S Corp Is Taxed

The profit of an S Corp is passed through to shareholders. Each shareholder pays their portion of the corporation’s income. The S Corp does not pay income tax. An S Corp with more than one owner must file an informational tax return like an LLC.

S corps must pay the non-income measure of the corporate excise tax. The amount of corporate excise tax an S Corp pays is determined by the corporation’s gross receipts and whether they are a financial institution. An S Corp has a minimum excise tax of $456 as of 2020.

An S Corp with gross receipts that are $6 million, but less than $9 million, must pay excise tax at a rate of 2.00 percent for tax year 2020. An S Corp with gross receipts of $9 million or more must pay excise tax at a rate of 3.00 percent for tax year 2020.

Taxation of Financial Institutions

S corporations that are financial institutions are taxed as financial institution S Corps under Massachusetts General Law Chapter 63 Section 2B.

An S corporation financial institution with gross receipts of $6 million, but less than $9 million, must pay excise tax at the rate of 2.67 percent for tax year 2020. An S corporation financial institution with gross receipts of $9 million or more must pay excise tax at the rate of 4 percent for tax year 2020.

Reducing Taxes for S Corp Business Owners

An S Corp business owner can reduce the self-employment tax by paying themselves a W-2 wage that constitutes reasonable compensation. Reducing this type of tax cuts the amount of Social Security and Medicare taxes that the owner pays.

The S Corp owner pays self-employment taxes as the employer and employee on that part of their compensation, but the rest of the compensation that they withdraw from taxes is not subject to self-employment tax.

An LLC member owner does not have this option. They are subject to self-employment tax on distributions they receive from the business.

When to Change Status

Owners should consider changing an LLC to an S Corp when certain events occur:

  • Enough member owners are being paid by the company that changing to an S Corp would save them money on self employment taxes.
  • A significant number of member owners want to be company employees.
  • Member owners want to be able to put money in tax-deferred retirement accounts that they are able to establish as employees of the company.
  • The company is ready to assume the typical burdens of a corporation.

Member owners of an LLC can experiment by electing to have the LLC pay taxes as an S Corp to the IRS. This does not transform the LLC into an S Corp. The member owners have to file the appropriate paperwork with the Secretary of the Commonwealth to effect a permanent change in the company’s status.