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Why “LLC or S Corporation?” is the 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 an 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 its important to understand that other entities 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 an 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 ask (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.

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