Is an LLC or a Corporation better when starting a new services business?

Naomi Kokubo

Naomi Kokubo

by Naomi Kokubo, Editor of Founders Space

I found a couple of interesting articles that might help answer this question.  One from Wikipedia on S Corporation, and here’s an excerpt:

S-corporations pay a franchise tax of 1.5% of net income in the state of California (minimum $800). This is one factor to be taken into consideration when choosing between a limited liability company and an S-corporation in California. On highly profitable enterprises, the LLC franchise tax fees, which are based on gross revenues (minimum $800), may be lower than the 1.5% net income tax. Conversely, on high gross revenue, low profit-margin businesses, the LLC franchise tax fees may exceed the S corp net income tax.

And another one that addresses the exact question that I found from S Corporations Explained site, and here’s an excerpt:

Which Entity Choice is Better: An LLC or an S Corporation?

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

Unfortunately, this question is impossible to answer. Here’s why. 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.

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 you probably want to use the LLC, for the reasons I give at the LLCs explained web site. (In a nutshell, 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.)

The second question people are asking (implicitly) is which tax entity classification they should choose for their LLC or corporation. 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.

You might also want to check out other answers in Answer Space that are related to S Corporation and LLC.

Note: Before making any business decisions based on information on this site, it is your responsibility to check with your counsel or professionals familiar with your situation.

Tip: Consider using a filing service such as Legal Zoom where they file all the documents with the state, get your record book, and more.

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