Should my business partner and I create an LLC or an S Corporation for our software company?
My business partner and I are starting a software company and are trying to decide between creating an LLC and an S Corporation. We will have no profits generated this calendar year, but would like to be fully protected and work the best tax angle. Which is the better choice for our situation?
Both the LLC and the S Corporation will provide you with similar liability protection and similar taxation at the federal level. Your state taxes could be slightly different if your state charges different fees for the LLC vs. the S Corporation. Because LLCs are established by state law instead of federal law, the rules will vary depending on the state you are in. To choose between an LLC vs. an S Corp, consider the following.
AMOUNT OF WORK
In most states, LLCs require much less ongoing paperwork and red-tape to maintain the legal entity. This makes them advantageous for small companies who don't have a lot of time and money to keep the S-Corp status alive.
If you have dreams of someday going public, you'll likely want to avoid the LLC status. Only a C Corp can be a publicly traded, and switching between a C Corp and an S Corp is literally as easy as checking a box and dealing with a few tax/accounting hoops. With an LLC, it is much more difficult to switch to a C Corp and often has terrible tax consequences.
S Corporations have restrictions on owners of the company, including owners can't be foreign investors. If you might seek foreign investors in the future, you would need to switch to C Corp status when these investors come on board. You would also want to check your state's laws to see if there are any LLC ownership restrictions which could make it difficult to attract future investors.
TAXATION IS A NON-ISSUE
Both the LLC and the S Corporation will allow you to get pass-through taxation, and both will allow you to elect to switch to double taxation (C corporation status) if that becomes advantageous. While it may seem like pass-through taxation is the better choice, you can actually end up paying far less tax under the double-tax status, depending on your circumstances. Your company (future) profitability, strategies for growth, and the types of compensation and benefits you plan to provide yourselves are major factors in this determination. A comprehensive financial advisor or CPA who specializes in working with business owners can advise you on which is better for your situation.
LIABILITY - GET MORE PROTECTION
Liability protection is mostly the same under the LLC and S Corp entities, although some states have special rules for LLCs (especially single-member LLCs). Also realize the limited liability for a corporation isn't all it's cracked up to be, and often times the benefits are oversold. Don't stop at getting an LLC/S-Corp, and instead make sure you guys get strong liability insurance for your businesses. Liability insurance will protect your business and your personal assets far more than the LLC/S-corp.
If you have additional questions, feel free to reach out.
An LLC partnership provides you with all the protection you need from a legal standpoint and there's flexibility with how you move money in and out of the business. S Corporations require you to pay "reasonable compensation" in the form of w-2 wages to the owners. When you become very profitable this can be beneficial from a tax standpoint as the profits are considered qualified business income, which can receive up to 20% automatic deduction (this means 20% of those profits are tax-free), the rest you just pay federal income tax on, no self-employment tax like you do with LLC income that's all qualified business income (bigger automatic deduction, but often more taxes). LLC's are a good option in your early years until you get to that point of needing the extra control S Corps offer over your tax situation. You can always elect later on to be taxed as an S Corp if you're an LLC. You simply file Form 8832 to change the election. Here's the IRS website with more details.