Let's assume that you've read all of Nolo's Legal Encyclopedia material on LLCs and corporations and that you now understand the chief legal, tax, and financial characteristics of the main types of business entities. Let's also assume that you've concluded it would be advantageous to operate your small business through an entity that limits the personal liability of all the owners -- even if following this strategy involves a bit more paperwork, complexity, and possible expense.

For the reasons explained in the encyclopedia articles, you've probably narrowed your choice between either the tried-and-true corporation or the new and streamlined LLC. Which is best? There's no universal answer that applies to every business. Nevertheless, some general principles may be helpful.

For the majority of small businesses, the relative simplicity and flexibility of the LLC make it the better choice. This is especially true if your business will hold property (such as real estate) that's likely to increase in value. That's because regular corporations (sometimes called C corporations) and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, LLC member-owners avoid this double taxation because the business's tax liabilities are passed through to them; the LLC itself does not pay a tax on its income.

But an LLC isn't always the best choice. Occasionally, other factors may tip the balance toward a corporation:

  • You expect to have multiple investors in your business or to raise money from the public. While an LLC works fine when you have just a few investors -- especially those who will be active in the day-to-day operations of the business -- it may get more awkward when the number of investors increases. For example, you'll likely run into resistance from potential investors if you can't offer them the corporate stock certificates that they perceive to be tangible evidence of their partial ownership of the business. Rather than wasting your time trying to overcome this resistance, it's better to structure your business as a corporation.
  • You want to set up a single-member LLC, but you live in a state that requires two or more members. Only three states -- California, the District of Columbia, and Massachusetts -- now require that an LLC have two or more members. (Of course, if you live in one of these states and are married, you can easily comply with the LLC rules by including your spouse as an LLC member.) But if for any reason you can't -- or don't want to -- meet this two-member rule, you'll need to incorporate to limit your personal liability. (Every state allows one-person corporations.)
  • You'd like to provide extensive fringe benefits to owner-employees. Often, when you form a corporation, you expect to be both a shareholder (owner) and an employee. The corporation can, for example, hire you to serve as its CEO and pay you a tax-deductible salary. From a tax standpoint, this option is far better than paying you dividends, which can't be deducted by the corporation as a business expense and therefore wind up being taxed twice. But corporate employees (including employees of a C corporation who are also owners) don't just receive pay -- most also receive fringe benefits. These benefits can include the payment of health insurance premiums and direct reimbursement of medical expenses. The corporation can deduct the cost of these benefits and they are not treated as taxable income to the employees. Having your own corporation pay for these fringe benefits and then deduct the cost as a business expense can be an attractive feature of doing business through a regular corporation. These opportunities for you to receive tax-favored fringe benefits are somewhat reduced if you do business as an LLC. Also, a regular corporation may be able to offer better retirement benefits or options under a corporate retirement plan.
  • You want to entice or keep key employees by offering stock options and stock bonus incentives. Simply put, LLCs don't have stock; corporations do. While it's possible to reward an employee by offering a membership interest in an LLC, the process is awkward and likely to be less attractive to employees. Therefore, if you plan to offer ownership in your business as an employee incentive, it makes sense to incorporate rather than form an LLC.

Choosing between an LLC and an S Corporation: Self-Employment Taxes Can Tip the Balance

You know that taxes are withheld from employees' paychecks. In 1998, for example, the law required employers to withhold 7.65% of the first $68,400 of an employee's pay for Social Security and Medicare taxes, and 1.45% of earnings above that amount for Medicare taxes. The employer added an equal amount and sent these funds to the IRS. The total sent to the IRS is 15.3% on the first $68,400 of wages. You may not be aware that the IRS collects a similar 15.3% tax on the first $68,400 earned by a self-employed person and a 2.9% tax on earnings above that amount.

For an S corporation, the rules on the self-employment tax are well established: As an S corporation shareholder, you pay the tax on money you receive as compensation for services — but not on profits that automatically pass through to you as a shareholder. For example, if your share of S corporation income is $100,000 in 1999 and you perform services for the corporation reasonably worth $65,000, there will be a 15.3% tax on the $65,000 but not on the remaining $35,000.

By contrast, the rules for members of an LLC are murky. Proposed IRS regulations would impose the self-employment tax on your entire share of LLC profits in any of the following situations:
  • You participate in the business for more than 500 hours during the LLC's tax year.
  • You work in an LLC (no matter how many hours you work) that provides professional services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting.
  • You're empowered to sign contracts on behalf of your LLC.

Until the IRS clarifies the rules on self-employment tax for members of an LLC, you should assume that 100% of an LLC member's earnings will be subject to the tax. Thus, using the figures in the above example, you should assume that the full $100,000 of your LLC income will be subject to the self-employment tax -- although the amount above the current year's Social Security tax cutoff figure will be subject only to the Medicare tax.

The point is that for now -- and until the tax rules are clarified -- an S corporation shareholder may pay less self-employment tax than an LLC member with similar income. You'll need to decide if this potential tax saving is enough to offset such LLC advantages as flexibility in management structure and distributing profits and losses.

You may need professional advice in choosing the best entity for your business.
Nolo's Legal Encyclopedia gives you a great deal of information to assist you in deciding how to best organize your business. However, it's impossible to cover every nuance of tax and business law that applies to your business -- especially if your business has several owners with different and complex tax situations. And keep in mind that sorting out the effects of pass-through taxation is no picnic, even for seasoned tax pros. The bottom line is that unless your business will start small and have a very simple ownership structure, you'll want to check with a tax adviser before you make your final decision on a business entity.

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