As the owner of a home-based business, you might consider it
desirable to seek a certain amount of liability protection for
your personal assets while maintaining a single level of taxation.
Until recently, the most popular means of doing this for a sole
proprietor has been to form an S corporation. Operating as an
S corporation combines the advantages of a single level of taxation
at the shareholder level with limited liability for the shareholder.
An S corporation has the same corporate characteristics as a C
(tax-paying) corporation. The only difference is that an election
has been filed with the IRS for the corporation to be treated
differently for federal tax purposes. The election generally permits
the income and losses of the S corporation to be reported directly
on the shareholder's Form 1040, thereby eliminating any tax at
the corporate level.
Drawbacks of an S Corporation
The drawback to forming an S corporation is that it requires
you to file a separate corporate tax return along with your personal
return, and the tax rules for S corporations can be pretty tricky
in certain circumstances. Because of the added return preparation
fees, tax accountants drool over clients with S corporations.
You should hire one with plenty of experience — not with
drooling, but in dealing with S corporations. An even better idea
though, might be not to form an S corporation at all, but to form
a limited liability company (LLC).
Advantages of an LLC
An LLC offers the same limited liability as an S corporation,
but has the additional advantage to a sole owner of uncomplicated
tax compliance rules. The LLC is a fairly recent phenomenon in
the United States. It is an organization formed under state law
to provide limited liability for its owners, who are called members,
in the same way corporate shareholders are protected. An LLC is
not a corporation under state law, however, which has caused uncertainty
about its federal tax status. Beginning in 1997, the IRS adopted
the simple approach of allowing most LLCs the choice of whether
they will be taxed as a corporation or not.
Taxing Scheme
An LLC with at least two members is automatically treated as
a partnership for tax purposes, and a single member LLC is treated
as a sole proprietorship, unless a form is filed with the IRS
electing to be taxed as a corporation. That means a sole proprietor
who forms an LLC has what is called a "disregarded entity,"
or "tax nothing," and simply files Schedule C along
with Form 1040, exactly the same way it was done before becoming
an LLC.
State Law
The primary drawback for sole proprietors forming LLCs has been,
until very recently, state laws regarding single member LLCs.
Most states now allow single member LLCs and conform to the federal
tax treatment, but check with your state department of revenue
for the latest information. Some states charge LLCs annual entity
level taxes, such as California where federal tax classification
is honored, but there is an annual minimum franchise tax and a gross receipts tax that needs to be considered.
