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 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 www.llcsexplained.com web site. (In a nutshell, LLCs are like "lite" versions of corporations. They give you all the same legal protection as a regular corporation only 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.