LLC taxation as S-Corp C-Corp or Sole?

[akumanov]

Hi,

I am looking to open up an online marketing service business. I am trying to decide which LLC taxation should I choose (Sole, S-Corp, C-Corp). Some quick things to know:

- I am the only owner so it's a single member LLC
- I am 16, so if I open the LLC this will be my first tax return form
- I am expecting to not reach $100,000 in yearly sales for a few years
- LLC will be registered under state of California

I understand that with the sole proprietorship path I will file a regular tax return and attach to it a schedule c for my LLC taxes. I want to know how much percentage will I be taxed for employment taxes (since I will be paying myself a salary)? How much would the company be taxed at the end of the year if I have a profit? Also, if I choose sole proprietorship taxation will I still have personal protection if my business's taxes get screwed up and the IRS comes after my business. Also, what I file bankruptcy, will my personal assets be protected? What is the benefits for me to file to be taxed as a sole proprietorship? What are the cons?


I am confused as to how an s-corp's taxation process works. Let's say that annually my income was $120,000 and my expenses were $20,000. So my gross profit was $100,000. Now I pay myself a $50,000 annual salary. The LLC now has $50,000 left as profit. Ok, now my questions are, what is the percentage on the self employment tax and how much do I have to pay? What is the taxes amount that I have to pay for the profit left over and what is the percentage? What is the benefits for me to file to be taxed as an s-corp? What are the cons?

C-Corp I'm not really considering as an option due to it's double taxation issue.

I know that it is always a good idea to hire a CPA/attorney to help with these things, but I don't have the funds for that at this moment.

Also, based on your experience/opinion what is the best way for me to choose to be taxed in my position and age?

[Business Attorney]

It sounds like you have really done your homework and have a pretty good understanding of the pros and cons of LLC versus S Corp versus C Corp, but I'll take a stab here.

First, let me say upfront that I am not in a position to comment on state taxation in California. State taxes can sometimes be a significant factor in determining which method of taxation is best.

Also, as I mention in my article Should Your LLC Elect to be Treated as an S Corp? (http://www.limitedliabilitycompanycenter.com/llc-electing-s-corp-status.html), if you have a single person entity and don't need the flexibility of an LLC, it may make more sense just to have a corporation electing to be an S Corp rather than an LLC. Again, that may depend on state income or franchise taxes. For example, in Illinois the initial and annual fees payable by an LLC are significantly more than for a corporation.

Here are a couple of answers and comments on your questions:

An S corporation pays you a salary that is no different than the salary it would pay to any other employee. There is a 7.65% Social Security tax paid by the employee (and withheld) and another 7.65% paid by the employer, for a total of 15.3% of the salary paid. There is no self employment tax on the amounts paid as dividends. However, you must pay a "reasonable" salary and cannot simply characterize all payments from the corporation as dividends.

All of your income allocated to you from your LLC will be subject to the 15.3% self employment tax (there is no designation of salary or dividends). In your example of making $100,000 and paying $50,000 in salary and $50,000 in dividends, the employment tax rate on the second $50,000 would be 0% in an S Corp and 15.3% ($7,650) in an LLC.

But the calculation does not end there. There are two income tax deductions that reduce your taxes in the LLC, but not in the S Corp.

First, your net earnings from self-­employ­ment are reduced by half of your total Social Security tax. This is similar to the way employees are treated under the tax laws, because the employer’s share of the Social Security tax is not ­considered wages to the employee.

Second, you can deduct half of your Social Security tax on IRS Form 1040.

The value of those deductions will depend upon your income tax rate.

The 15.3% applyies up to the base salary amount, which in 2010 is $106,800. If your net earnings exceed $106,800, you continue to pay only the Medicare portion of the Social Security tax, which is 2.9%, on the rest of your earnings from wages or self employment (but not S Corp dividends).

Another thing to keep in mind is that with an LLC there are no employment tax returns. You simply report the amounts on your Form 1040 (although you may need to pay quarterly estimated taxes during the year). With an S corporation, you must withhold and remit taxes to the IRS from every payroll and file quarterly returns. There are very substantial penalties and interest for failure to comply with either the remittance or the return requirements. So your savings in self employment taxes will be offset to some extent by the added cost and hassle of filing the payroll tax returns.

Hope this helps.

[vangogh]

I don't know if it helped akumanov, but I learned a lot. The more you talk about it the more I'm beginning to understand how all these corporations work.

[Evan]

David is correct, you do want to look at the initial start up costs of each entity, and what taxes may exist for each entity. California has very high taxes on business, so you don't want to treat this decision lightly.

You also need to see whether you're allowed to form a legal entity, as state law, by virtue of your age, may prohibit you from forming any entity, or serving as a director, officer, member, etc. I ran into this problem myself when I was first starting my business. You are also going to have a lot of skeptics at an early age, and even if you organize, a bank may prohibit you (by their policy) from being a signer on a checking account. There are a lot of road blocks to young entrepreneurs.

I am a big advocate of people operating as a sole proprietorship until they reach a point where they realize the business is sustainable. I think a lot of attorneys and accountants prematurely tell clients to incorporate or organize early on because it's easier for them with paperwork, but the fact is you have no idea whether this business is sustainable. Organizing just requires you to comply with a few more laws to prevent a lawsuit that may or may not happen in your infancy. Your best bet is insurance, as no entity is going to protect you from complete liability in many cases.

Once you get a few dollars rolling into the business, and think that this is definitely going to be going big -- then you should be able to afford the services to get your legal entity up and going.

I have seen many LLCs, S-Corps, and C-Corps fail miserably, and they were formed with the thought they'd be the next Microsoft, Facebook, or Google, and in most cases that isn't going to happen.

[Business Attorney]

Evan has raised a good point. I was answering your specific questions but the very first question is: do you really need an entity?

I started a niche mail order business in high school and a different mail order business while in college. Both were sole proprietorships. I have a rental property that I own in my own name and two other rental properties that a friend and hold jointly in an Illinois land trust, again with no entity (although we did incorporate a separate management company back when we were managing the properties ourselves).

Although there are other reasons to form an entity, the primary reason is to protect the owner from liabilities of the business. For a one-person company, the protections may be considerably less in reality than they are in theory. I have an article How Limited is Limited Liability? (http://www.limitedliabilitycompanycenter.com/how_limited_is_limited_liability.html) that discusses the point in some detail.

In addition, for some types of business, it is very unlikely that there will be any personal liabilities. I don't know what your "online marketing service business" will be doing, but it is probably not going to be doing anything that will expose you to significant liabilities.

Finally, if you have no assets (any most 16 years olds do not), then exactly what are you protecting from those liabilities? If you have nothing to protect, then that is another reason that an entity may be overkill.

On another point Evan raised, if the age of majority in your state is higher than 16 (and most states have 18 as the age of majority), then you may have issues. On the other hand, I started a business at 16 and was never asked once about my age by my suppliers, by my customers or by the publications that I ran ads in. I had my own checking account in my own name (since it was a sole proprietorship). One of my parents may have technically been on the account, although I don't think so. Of course, that was long before the Patriot Act and its know-your-customer rules that banks must strictly follow today.

[Evan]

When I was 13 with my own business, I had one of my parent's on the checking account -- they allowed that (after a bit of pleading). I switched banks a few times, and 16 was the magic age where they let me open an account without my parents. I've been with that bank since then, and am one of their "preferred" customers now that I have many business accounts there. (I worked with many non-profits, who bank there because of me. My family also does their business there as well.)

So while they may view you as a small fry, you do have a lot of power! :)