Why "LLC or S Corporation?" is Wrong Question

"S Corporation or LLC?" is a common question for new business owners.

Unfortunately, this question is tricky to answer in a satisfying way unless you learn a little tax law. But the question is easy to answer once you do understand a wee bit of tax law. Let me explain.

Here's the first thing you need to know: An S corporation isn't actually a corporation. Rather, an S corporation is a entity that's made an election with the Internal Revenue Service to use a set of tax accounting rules detailed in Subchapter S of the Internal Revenue Code.

Historically, only corporations were allowed to make this election--which explains why people still use the label "Subchapter S corporation" or "S corporation" to refer to entities that use the Subchapter S tax accounting rules. But here's the important thing to understand: Other entites can use these tax accounting rules, too.

So now here's the second thing you need to understand. An LLC is a chameleon for income tax purposes, so it can be anything the owner wants it to be. For example, an LLC with one owner can be a sole proprietorship, a C corporation or an S corporation. And an LLC with multiple owners can be a partnership, a C corporation or an S corporation.

What all of the foregoing means is that you actually don't need to choose between an LLC and an S corporation. You can form an LLC and have the LLC treated as an S corporation. And this means the "LLC or S corporation" question is, well, nonsensical.

The first "right" question to ask about LLCs and S corporations

I think what people asking "LLC vs. S corporation?" really want are the answers to two questions.

The first question people are asking is which legal entity--LLC or a traditional corporation--they should use as the starting point for a business. My answer to this first question is that if you're visiting this website to learn about LLCs and S corporations and if you're maybe going to form an LLC or S corporation yourself, you probably want to use the LLC.

LLCs are like "lite" versions of corporations. They give you all the same legal protection as a regular corporation but with half the calories--er, I mean, red tape. LLCs are also easy to set up yourself and to safely operate yourself.

The second "right" question to ask about LLCs and S corporations

The second question people are asking (implicitly) is which tax entity classification they should choose for their LLC or corporation. And this question is a little trickier to answer. As noted earlier, an LLC can be just about anything. And a corporation can generally be either a C corporation or an S corporation.

Making a smart tax entity classification decision is tricky and something you'll want to consider carefully. Here are some of the issues to consider:

• Investments and businesses that produce losses are often best operated as a sole proprietorship or partnership so that the losses pass through to the owner's or owners' tax returns and create tax deductions.

• S corporations are often best if the LLC operates an active trade or business and self-employment taxes on the owner or owners are high. Note, however, that not every business is eligible to become an S corporation.

• If an LLC holds real estate or other passive investments, an S corporation or C corporation is usually a very poor choice since the corporation may create an extra level of taxation.

• If an LLC operates an active trade or business that does business in many states, a C corporation is often easiest for the owners because a C corporation probably reduces the multistate income tax accounting burden for the owners. Note that multistate tax accounting often becomes very cumbersome for shareholders of an S corporation.