LLC formation (taxed as S-Corp)

[geneyes]

I met with an attorney recently and he said for our business we should do an LLC and have it taxed as an S-corp. I am not 100% sure why this would be.

Here is the background:
Three people in the company (not owned evenly)
Expecting $80K+ revenue first year and about $300K next year, all money is reinvested in the company until we start making more than a couple of million per year.
Will form the LLC in Arizona.

I don't get how an S-corp taxation would save any money over an LLC if they are both pass-through. I don't plan to have any health insurance or such for employees or founders any time soon, at least not in the first two years. If we ever get big enough to IPO the attorney said we just incorporate in Delaware, but that is a completely different subject.

I hope that someone here can explain why he would recommend doing an LLC taxed as an S.

P.S. Since it is pass-through income but we are keeping any money in the company (although we'll try to spend it all that year), the company will pay the taxes for us.

Thanks for the help!

[Evan]

I'd recommend S-Corp status as well. When you file your Articles of Organization, select to be taxed as a corporation. There are a few forms you'll have to file (sorry, I know OldJack can give you form #s) to change the status to a S-Corp. All of the members of the LLC must agree to this, however, so make sure that the members you're working with will also agree. (Even if you decided to be a Corporation, you'd need everyones agreement).

If you don't choose to be taxed as a corporation, you'll be paying self-employment tax on top of that because your entity will be treated as a partnership. Personally, if your expecting million dollar revenues, I'd think (though I'm not qualified to say this) that being a C-Corp would be your best bet as that is a lot of revenue to carry over to your 1040.

[OldJack]

Who were you planning to sue? Did you also meet with an accountant? I agree with Evan.

[Evan]

I think from the lawyers "legal standpoint" an LLC may be better because of the outside, the "loose structure" and how it can be taxed as anything. An accountant may be able to plug in these numbers and tell you from a tax standpoint which would be best.

[OldJack]

Evan has a good point on the loose structure. Personally, I think the loose structure is what will cause many loose operations to be surprised with unexpected tax problems.

As an example, say the LLC has unequal owners.. say 80%-20%, but the ownership agreement may be to split profits on a 50-50 basis. However, an S-corp taxation requires split on a "per share" ownership basis or capital account 80-20 basis, no exception. The owners go along all year distributing cash on the 50-50 basis but when tax time comes the 20% owner is very happy because the 80% owner has to report and pay 80% of the tax.

[Clayton]

Originally Posted by OldJack

As an example, say the LLC has unequal owners.. say 80%-20%, but the ownership agreement may be to split profits on a 50-50 basis. However, an S-corp taxation requires split on a "per share" ownership basis or capital account 80-20 basis, no exception. The owners go along all year distributing cash on the 50-50 basis but when tax time comes the 20% owner is very happy because the 80% owner has to report and pay 80% of the tax.

I guess this is just an example, but who in their right might would invest 80% of their money into a company and then split the profits 50-50? If you have a good operating agreement you could solve that problem right there.

I just formed a single member LLC in Arizona and in my situation using the pass-though benefits of the LLC will be fine.

What you need to do is call this person back and ask them, I'm sure they've got a good reason.

[OldJack]

Yes Clayton, it is just an example about one specific LLC electing S-corp status. The right minded person (80%) might be a partner with money and no intent to devote time in the business with a full-time working partner that is an expert (20%) in the type business but has no money to invest. I am sure that the 20% partner would have an agreement/option to buy-out the 80% partner. But that doesn't change the 80-20 mandatory profit split requirement of the S-corp tax status. The LLC agreement may spells out 50-50 but due to the S-corp election it is ignored for tax purpose. We were simply discussing problems that might be with any LLC electing to be an S-corp.

I personally do not recommend LLC's electing S-corp because there are so many problem "surprises" (such as the example) that the owner/taxpayer may be unaware of until they get the IRS audit tax bill plus penalties.

Some LLC owners elect S-corp status but still think and act LLC. If the LLC elects S-corp status, then they have to be like an S-corp.