LLC vs S corp formation: Factors to consider
Business owners often get tangled up in the "llc vs s corp" question. Sometimes even attorneys and accountants get tangled up trying to provide advice when clients ask about choosing between a limited liability company versus an S corporation.
Unfortunately, this question is impossible to answer because it's nonsensical. As noted elsewhere on this web site, a limited liability company, or llc, is a chameleon for income tax purposes.
Basic Rules for LLC Taxation
An llc that operates an active business and that has one owner can be a sole proprietorship, a C corporation or an S corporation for income tax purposes.
And a limited liability company, or llc, with multiple owners can be a partnership, a C corporation or an S corporation for income tax purposes.
In other words, you don't ever actually make an "llc vs S corp" choice. Rather, after setting up an LLC, you either accept the default tax accounting classification... or you elect to have the LLC treated as a regular, C corporation or as a Subchapter S corporation.
Making Sense of the Limited Liability Company Vs. S Corporation Choice
Accordingly, what people should really want to know when they consider the "llc vs S corp" question is which tax accounting classification they should choose after they finish with the work involved in an llc formation. In other words, the right question to ask is NOT whether someone should choose an llc over an S corporation or vice versa. The RIGHT question is what type of tax accounting treatment should someone choose for their business llc or investment llc.
For example, if someone already owns an llc or someone plans to set up an llc, should they simply accept the default classification (either sole proprietorship or partnership) for their limited liability company or should they elect to have the llc reclassified for income tax purposes as a C corporation or an S corporation?
Rules of Thumb for Choosing Optimal LLC Taxation
Making a smart limited liability company 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 the limited liability company and onto 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.
- You can sometimes combine entities and get the best of both worlds. For example, you can create a partnership of S corporations in certain circumstances.
- Often times, you'll want to have an active trade or business llc treated as a sole proprietorship or partnership in the early years of the business when profits are modest or there are losses. Later on, when the business is profitable, you'll want to have an active trade or business llc treated as a C corporation or S corporation. (An llc makes this sort of transformation very easy.)
- 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 the business can often reduce the multistate income tax accounting burden by choosing C corporation taxation after forming an llc.
State Tax Considerations When Considering LLC vs S Corp Issue
In general, states treat S corporations (and limited liability companies opting for S corp status) the same way that the federal government treats S corporations. For example, if you make a valid S election with the IRS for federal income tax purposes, most often your state also honors that federal S election for state purposes. As another example, in general, S corporation shareholders are subject to state income taxes on their proportional shares of the S corporation's profit--just as they're subject to federal income taxes on their proportional shares of the S corporation's profit.
Numerous little exceptions to these general rules exist, however:
1. Some states do not recognize S corporations--in other words, they treat S Corporations like C corporations. At the time of this writing, the District of Columbia, New Hampshire, and Tennessee fall into this category. Note that you can still have an S corporation in these states--and that can still mean big federal tax savings--but the S corporation will only be an S corporation for federal tax purposes and not for state tax purposes. For state purposes, the corporation will be treated as a regular C corporation.
2. Some states tax S corporations on part of their income even though they do recognize the S corporation. For example, Massachusetts taxes S corporations on their profits when the profits rise about a specified limit. (Note: Shareholders in Massachusetts S corporations are not taxed on their shares of this "taxed" S corporation income.) Several other states tax shareholders on the S corporation's income and also tax the S corporation on some of its income. For example, in both Indiana and Kentucky, while shareholders get taxed on their proportional shares of the S corporation's profits (meaning the state has taxed all of the business's income), the S corporation also pays taxes again on capital gains and on excess passive income. Idaho, Maine and Wisconsin play a similar game with S corporations.
3. A small handful of states, including Michigan, California, New Jersey and New York, tax both the S corporation's profit. and the shareholder's proportional shares of the S corporation's profits. This means that in a sense the S corporation is double-taxed in a manner similar to a C corporation that distributes all of its profits as dividends.
Michigan, for example, taxes the S corporation shareholder on all of his or her income because Michigan does recognize the federal S corporation election for purposes of passing through S corporation profits to shareholders. Michigan also taxes the corporation on that same income via its single business tax. Fortunately, most small businesses--the sorts that would elect S corporation status--either aren't subject to the single business tax or don't pay very much single business tax. (At the time I'm writing this, a business is exempt from the single business tax if its gross receipts are less than $350,000. Michigan may just win the dubious honor of being the worst state in the nation to setup an S corporation.)
California, New York and New Jersey also tax both the corporation and the shareholder on business profits. Fortunately, in these three states, the state corporate tax rate levied on the S corporation's profits is modest. In California, for example, the S corporation tax is often a flat $800 a year.
4. In general, if an S corporation does business in another state (other than the home resident state), that other state will want to tax all shareholders--even nonresident shareholders--on their proportional shares of the S corporation's income earned in that other state. Some states as a convenience let the S corporation pay the income taxes owed by shareholders or nonresident shareholders.
As a final general comment about the state taxation of S corporations, let me suggest that if you want to turn an LLC into an S corporation or if you want to set up a new S corporation, it's a good idea to call the state income tax agency where the S corporation will operate and ask two questions: One, whether there's a separate state S corporation election form that needs to be filled out. And two, if they have any information they can provide to you concerning the taxation of S corporations. You obviously don't want to be surprised.
Using an Incorporation Service or Kit to Form an S Corporation
If you want to use the S corporation tax accounting rules for an LLC, someone needs to prepare additional paperwork as part of your formation--specifically, someone needs to prepare and submit to the IRS a form 2553 at the start of the first year in which you want to operate as an S corporation.
Note: Our do-it-yourself kits step you through the S election paperwork. Further, while our standard $199 overnight incorporation service doesn't include preparing the 2553 paperwork, we will prepare incorporation documents that include the 2553 form (and when necessary the equivalent state S corporation election) for $299. (If you're interested in our overnight incorporation service, please email steve.nelson@stephenlnelson.com.)