Deciding on LLC doesn’t completely decide your Entity.

The Limited Liability Company is a relatively new entity, and is strictly a “state” entity.  The IRS doesn’t recognize LLCs for tax purposes.  So, if you decide on becoming a LLC, you still have to decide (or the IRS will decide for you!) how you want to be taxed.

With the LLC you get ease of set up and limited liability.   There is also less administration for the LLC.  But how are you taxed?  If you are a single member LLC (just you and no one else, not even a spouse) then if you don’t choose differently, the IRS says by default you are a disregarded entity.  This means that you’re taxed just like any other sole proprietor on a schedule C or F (if you’re a farmer).  As a single member LLC you could also choose to be taxed as a corporation or even a corporation that elects S status.  But you can’t be a partnership — takes at least two.  If you have more than one member of the LLC, then by default the IRS taxes the LLC as a partnership.  However, you can choose to be taxed as a corporation or a S corporation.  With the limited liability and ease of set up, this is a pretty good deal.

S Corporations

A S-corporation is a regular corporation that has made an election with the IRS for S status, meaning mostly that the corporation is not taxed and all profit and loss is taxed to the individual shareholders.

The S corporation, like the regular corporation, enjoys limited liability.  There is also the same ease of transfer of interests via “stock” and unlimited life of the corporation.  However, unlike a regular corporation, a S corporation is limited to 100 shareholders and can only have one “class” of shareholders.

Most importantly, the S corporation does not have the double taxation of the regular corporation.  For profit/loss and fringe benefits the S corporation is treated by the IRS much the same as a partnership.  Although the corporation files a separate tax return, form 1120S, it is not taxed.  Profit or loss is reported via a K-1 on the shareholder’s individual return.

The S corporation is a strange bird.  With the structure of a corporation and the flow through of a partnership, the S corporation has rules galore!  The IRS form 1120S should not be attempted by someone not very familiar with the rules for S corporations.  I’m not a S corporation, but they are my favorite entity.

An Old Fashioned Corporation

The regular corporation (or C Corporation as it is sometimes called) has been around for a long, long time.  And of recent, hasn’t been the entity of choice for most businesses.

A corporation is the most costly of the entity choices to set up, and this includes both regular corporations and S-corporations.  Legal services are required and there is considerable red tape to administer them.  Corporation meetings along with minutes documenting all actions are required.  The IRS requires a form 1120 to be filed, and hence one of the biggest strikes against —  double taxation.  The profits of the corporation are taxed at the corporate level and then the dividends that stockholders receive from the corporation are taxed at the individual level.  Definitely a downside!

The corporation does provide limited liability.  And there is ease of transfer via “stock”.  The life of a corporation is not limited by the stockholders.  Another upside is the ability to deduct fringe benefits of the owners.  Aside from non-discrimination rules (you can’t have benefits for the owners and not for other employees), a corporation can deduct health insurance, some life insurance, pension plans, etc.  Is it worth the extra costs and red tape?  Most people think not.  Just FYI, I’m an old fashioned corporation.