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
Brian hit on some of the most salient tax issues facing your decision to be an LLC vs. an S Corporation, so I won't rehash his articulate discussion.
Whenever I advise clients as to which entity to choose, I usually go through a 4 page checklist. If the client is still awake after the 25 minutes, I put the checklist away and ask them the following basic questions:
1) Are you planning to hold appreciating assets in the entity, such as a building or art work? If so, then the LLC is the better entity.
2) Will personal services be the core revenue generator of your business, or will it be machinery or the buying-selling of a product? Depending on your answer, one entity type would be preferable to the other. Sorry I am being vague about this item, it's too complex for the scope of my reply.
3) Do you need the discipline of having a W-2 and withholding taken out of a paycheck? Then the S Corp is your entity. LLC members are prohibited from having salary.
4) Do you like paperwork, formalities, worrying whether you inadvertently terminated your S Corporation election? Then the S Corp is for you. Yes, the S Corporation is laden with formalities: corporate minutes, reasonable compensation, distributions in excess of basis. Also, if you lend money to your S Corporation and then deduct losses that use your loan as basis and then later repay your loan you will be subject to tax on the loan repayment. I know, you were told that you can repay your loan anytime!
Let me touch on the S Corporation termination issue: let's say that you decide you want to sell product to Cuba (this could happen in our lifetime) and you need to have a Cuban National own shares in your entity (just an example) in order to sell to Cuba. Oops!, there goes your S Corporation election - foreign nationals are prohibited from being S Corporation shareholders. You are now a C Corporation with the potential for that dreaded double taxation we all hear about.
5) Do you like to pay money to your CPA. Our firm spends more time on S Corporation issues than on any other type of entity.
Please don't interpret my snide remarks about S Corporation to mean that I don't like them or that I favor LLCs or, by implication, think they are right for you. In fact, they are phenomenal entities, but for the right reasons. Only your CPA can really determine which entity is right for you.
The information provided in this reply is for information purposes only and is not intended to be construed as accounting, tax, or legal advice.
Stephen R. Hartfield, CPA
IRS CIRCULAR 230 DISCLOSURE: To comply with requirements imposed by the Department of the Treasury, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written by the practitioner to be used, and that it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer, and (ii) supporting the promotion or marketing of any transactions or matters addressed herein.