Reader mail: LLC vs. S-corp

A reader writes in with an increasingly common dilemma:

Right now we are in the research phase (I am the sales, marketing, and product / customer / competitor research team - who says there's no I in team:-) Hubby and co-worker are top notch developers, but not really well versed in any of the other parts, so there's a lot of weight on me.

I've completely eliminated partnership, and C corp from the running - so it's really between S Corp and LLC.

My understanding is that both provide for pass through income (more questions about this later), but that with an LLC you can split the membership into unequal parts (in other words the income / expense or membership split in determined at the initial filing (is this correct?), where with an SCorp it is an equal sharing. We are interested in doing a 33% share for the co-worker, a 31% share for me, a 31% share for hubby, and giving each of our 5 kids a 1% share. From my understanding an LLC would be the best way to go.

I'm having trouble understanding the pass through income part. Let's say that the company in its first year produces an income of $100k unevenly over the course of the year. The company had minimal capital to start (maybe $1000), so no one is drawing a regular salary and there are no benefits. Everyone gets paid when there is a sale, which should occur once per month (we sincerely hope:-). Since the income passes through do you just pay everyone whatever their share percentage is? How do you allocate expenses - is it divided again by way of the percentage of shares. When passing through the income for federal taxes do you pass through all of the income and then each individual member gets to "write off" a percentage of the expenses, or do you deduct the expenses from the LLC return and then pass through the "net" income to the members?

What about franchise tax? The state comptroller's office said not to really worry about it, only the largest corps actually have to pay something even though every corp (with a few exceptions) has to file a return - what has your experience been with this? Also, can we be our own registered agents?

Okay...I realize that you are (probably) not an accountant, and (probably) not an attorney - I just seem to be really stuck on not being able to understand the financial side of this which is frustrating because I'm usually able to decode these things (and we definitely can't afford an accountant:-)

Thanks in advance for your help.

--Vexed in Texas

Dear Vexed:

First of all, you're right--I'm not an accountant or an attorney, so this is purely for educational purposes and not to be construed as legal or financial advice.

Now that I've kept our lawyers happy...

For starters, an S-corp can be split hower you want it. You issue X number of shares and allocate them to the owners proportionally. The point of confusion may be that the profit distribution has to be proportional to the share ownership. Of course, that's after salaries are paid, but I'm getting a bit ahead of myself. In short, you can split S-corp ownership however you want.

With an S-corp, you have to pay people – at least on paper – a fair market salary for the job they’re doing. If the money’s not there, you generally defer the salary. With an LLC, though, the owners are essentially self-employed. So, if you make more money than fair market salary, in an LLC, you’ll be paying extra employment taxes, because all of your income will come as “self-employment” income, whereas in the S-corp, anything over fair market salary is a profit distribution, not “wages”, and only subject to your normal income tax, not employment taxes.

But paying more in employment taxes isn’t necessarily a bad thing. Tracking and filing quarterly payroll taxes is a lot of recordkeeping, and it costs you time, and perhaps money, to do. On the other hand, with an LLC, you’ll have to make your personal quarterly estimates, but you only have to actually calculate and file your self-employment tax with your personal tax return.

So purely based on taxation considerations, if you’re expecting to make about fair market salary or less, you’re probably better off with the LLC. If you expect profits to be enough higher than fair market salary to justify the additional payroll record-keeping costs, then S-corp makes more sense. There are also some differences in flexibility re: ownership, but those generally only apply with larger numbers of shareholders.

Regarding franchise tax, in Texas it's only paid on your retained capital, i.e., whatever money you leave in the bank and other corporate assets. For a service company such as yours, in an S-corp or LLC that's distributing most of its profits, it should be very, very small.

I hope I've answered your question. For more information, including some sample calculations regarding the tax advantages, see:
S-Corp vs. LLC
LLC information at Nolo.com
S-corp information at Nolo.com