It goes without saying that the LLC is the media darling when it comes to choosing an entity for small businesses. In some cases, however, an LLC is at a disadvantage compared to an S Corporation.

Originating in the late 1970s in Wyoming, Limited Liability Companies have rise to loft heights. They are arguably the single most popular and most used entity for small business start ups. Why is this? Well, the LLC offers the tax advantages of a partnership along with the liability protection of a corporation. At the same time, the LLC does not require owners, known as members, to comply with the formalities of a corporation. In truth, said formalities are pretty simple, but there you are.

So, is an LLC always the best choice for a small business just getting rolling? When it comes to legal issues, you should know there is never a situation where “always” is going to be appropriate. This case is no different, particularly if we are talking about a single owner LLC.

States love to generate income from business entities. To create an entity, you have to pay a fee. To keep it running each year, you have to pay a fee. To make any modifications to the structure, you have to pay a fee. You get the idea. In there haste to embrace the LLC, most states allow for a single owner LLC. It sounds like a great entity opportunity until one gets around to paying taxes. Then the benefits of an LLC come into question.

A single owner LLC runs into a unique quark in the world of taxation. Simply put, the IRS does not recognize the viability of single owner LLCs for tax purposes. Instead, the agency simply treats these entities as sole proprietors. This means the owner must report the finances of the LLC on schedule C of his or her tax return. The owner also must pay the 15.3 percent self-employment tax on the full profit of the LLC. Ouch!

For sole ownership situations, the S corporation is usually a better bet than the LLC for tax purposes. Yes, it requires you to comply with a few more corporate formalities, but this is hardly difficult since you are the only owner! In a tradeoff for a bit more work, you get a major tax break. You can avoid part of the self-employment tax from the earnings of the corporation by claiming part of them as a dividend instead of payroll.

How much can be claimed as a dividend? Well, the IRS expects you to take a reasonable salary from the company. Arguably, this is what others in your industry would be paying. Since that is a rather vague figure, a better approach is to sit down with your accountant and come to a decision what the two of you could justify if the IRS came a knok’n! Regardless, the avoidance of the 15.3 percent self-employment tax is a major advantage afforded by the S-corporation over the LLC.

Richard A. Chapo is an attorney who helps businesses incorporate in California and can be found at SanDiegoBusinessLawFirm.com.

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