S corporation versus LLC

Many people starting a new business start out with an LLC over an S corporation.  Mostly they do this because they assume everyone else is correctly using an LLC over an S corporation and/or they haven’t discussed the matter with a tax advisor.  They jump on Legalzoom.com (ughh) and form an LLC, without thinking through the tax consequences of their choice.

An S Corporation versus LLC have the same basic liability protection, so the real choice is one of taxation.  An LLC formed with a single member is by default “disregarded” by the IRS, which means the individual running a business with a single member LLC is going to report his income and expenses the same as a sole proprietor who is not a company – on schedule C of his personal tax return.  Reporting on schedule C means you are paying self employment tax on a large chunk of your net income, at 15.3%.  This is fine if you want to pay into the Government’s “nanny” system, but I assume if you are reading this you don’t want to pay more tax than you have to.  Also, reporting on schedule C will likely subject you to a higher rate of audit than if you reported on an S corporation return.

An S corporation reports on an information return, form 1120-S.  The individual shareholder (you) reports his share of profit and loss on his personal return through a form K-1.  While K-1 income is subject to federal and state income tax, it is NOT subject to the 15.3% self employment tax.  However, the IRS will not take kindly to nobody taking a salary and paying any of that tax, so you may have to split up some of the profit as salary (subject to payroll tax) and some as k-1 income (not subject to payroll tax).  In the formative years of the S corporation, many people get away with taking little or no salary the first few years without an eyebrow raised.  Of course, you should review this strategy with your tax advisor.

Finally, if you already formed a single member LLC, you can convert it to an S corporation for tax purposes and achieve the same result.  If this is the case, contact use for assistance and we can get it done in a wink!

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