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In most cases, it is best to elect to be taxed as an S corporation. The main reason being that the rules for reasonable compensation for an S corporation are much more established then the self employment tax and guaranteed payment rules for the LLC.
More than 2% owners of an S corporation have to take a reasonable amount of wages for the work they are doing, and then any additional net income is not subject to self employment tax. This is a great strategy, but make sure your salary is in fact reasonable and close to what you would pay a manager to do your job. The IRS has started auditing this issue heavily, and they do look at salary guides, how much you are taking in distributions, and requesting a long list of information to support your number, so just don't get too aggressive.
In contrast, LLCs have no finalized rules on how much of their income is subject to self-employment tax. Rules were proposed by the IRS and never finalized back in the late 90s, and then Monica Lewinsky distracted Congress and the issue has never been addressed since. Despite this drawback, in most non-professional businesses, you can get a tax advantage very similar to the S corporation by bifurcating the LLC membership. However, it does require a lawyer to draw up the agreement and a CPA that is familiar with the strategy.
Despite the S corporation advantage with self employment tax, the entity is not without some disadvantages:
- S corporation distributions have to be proportionate to ownership interest, whereas LLCs are much more flexible in this regard.
- Debt in an S corporation does not give basis to the shareholders like it does in an LLC - even if the S corp shareholder guarantees the debt. It only works if in the shareholder name directly. Some CPA are more aggressive with this issue, but the IRS is fairly strict on it. This can be a major disadvantage for a business with losses that were paid for with large amounts of financing in the name of the business.
- If you have a professional service business, you need to be aware that Congress has twice tried to make the net income after reasonable compensation subject to self employment tax. It may never happen, but they are looking for revenue raisers right now, and that would kill the S corp benefit for many businesses.
There are many other considerations and complexities, so make sure you talk to your CPA.
Brian Germer, CPA