My wife has an established service business which we have been operating as a "Sole Proprietorship" for several years. For both liability and tax reasons, I feel the time has come to either Incorporate or create an LLC. The liability reasons are obvious but the tax reasons are a bit more complicated. One major goal is to reduce her self employment tax (which we all know is a lousy investment) so that we can take more responsibility for our own retirement. I'm told an S-Corp is the best choice for this type of strategy. Now I find this new entity called an LLC. According to the IRS, an LLC can choose to file as a Schedule C, a Partnership, an S-Corp, a C-Corp, or any other type of return. So what is the difference? Should I incorporate and file an 1120S? Or should I create an LLC and file an 1120S anyway? In my state (New Hampshire) there is no difference in filing fees or administrative burden between an LLC and a Corporation. If an LLC can file any federal tax form it chooses, then what is the advantage? Conversely, if I want to file as an S-Corp, why not just become an S-Corp?

Thank you all so much in advance for your time and advice.

Honestly, I think the LLC is the best choice. The only major difference between the LLC and s-corp is that if you have employees, and you need several types of liability insurance, an S-Corp would better suit you. But I run a business and I have no employees. Everything gets written off. I don't even have to pay myself a salary because, for example, I needed a car, the business bought it for me with untaxable income. I don't get taxed and the business doesn't get taxed. Now, if I ever decide to expand, which is possible (not right now because I'm still in college) than I will Incorporate. But realize, you can start as an LLC and if things grow a lot you can always merge into a Corporation. Here in Iowa, the merger only costs $25 + lawyer fees. You can't beat that.

Share what your business is and what you do and I can ask my lawyer what he thinks free of charge.

LLC is a legal entity, not a tax entity.

The IRA requires a tax return from the business either as a sole proprietorship (the default unless you take steps to establish either a partnership or a corporation).

Sole proprietorship requires the least amount of paperwork, but incurs the highest tax rates.

Partnerships and S corporations are pass-through entities, in that all income and deductions pass through the partnership/S corporation to the partners or corporate shareholders to claim on their personal tax returns.

C corporations are completely separate tax entities which pay income taxes just like individuals, only on a different (somewhat lower) tax rate.

The income from a partnership is reported as self-employment income on which you MUST pay self-employment taxes at 15.3% and income taxes at whatever your tax rate is.

At least in its early stages, you can get away with NOT paying self-employment taxes on the profits from the S corporation (which is passed to you as dividends). However, as the corporation becomes more profitable, the IRS will begin to look at how involved you are in the corporation and expect the corporation to hire you as an employee so that they can collect Social Security and Medicare taxes from you and the S corporation. Failure to foresee this can result in a VERY high tax bill (the penalties and interest on employment taxes can exceed 150%).

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Originally Posted by AtlantaTaxExpert

LLC is a legal entity, not a tax entity.

At least in its early stages, you can get away with NOT paying self-employment taxes on the profits from the S corporation (which is passed to you as dividends). However, as the corporation becomes more profitable, the IRS will begin to look at how involved you are in the corporation and expect the corporation to hire you as an employee so that they can collect Social Security and Medicare taxes from you and the S corporation. Failure to foresee this can result in a VERY high tax bill (the penalties and interest on employment taxes can exceed 150%).

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Thanks... My intention however was not to avoid paying SE taxes entirely, but rather to pay a reasonable salary and distribute the rest of the profits as dividends. For example, as a sole proprietor, we pay the 15% SE tax on ALL profits (up to the max of $94K or whatever it is.) A reasonable salary for her line of work might be only $45,000 annually. So if the business nets $100,000, she takes a $45,000 salary and the balance is distributed as a dividend free of SE taxes. It is my understanding that this is a perfectly legitimate strategy provided the salary is reasonable. Am I correct in my thinking here?

Thanks

Yes, you are correct that an S corporation must pay reasonable salaries to its employees.

I agree with IntlTax.

As long as you can show that the salary you pay your wife is in the ballpark of what other people in her line of work makes, you'll be fine.