Form as LLC or S Corp to reduce tax liability

Question

Drafting a business plan, trying to determine whether an LLC or S Corp would produce a lower tax liability (in the scenario below I am "Partner A"). Three Partners: Partner A, Partner B, Partner C

Year 2015: Partner A who will be doing all the work for the year 2015, makes no financial contribution. Partner B contributes $100,000 and does no work for the company. Partner C contributes $50,000 and does no work for the company. Parter A will receive salary of $100,000. $50,000 will be used for business expenses. Profit for 2015: $0.

Year 2016: Partner A continues to receive salary of $100,000. As in 2015, Partner A does all the work, Partners B & C do no work and will receive no salary. Company profit of $4,100,000. Losses: $0. Profit will be distributed amongst A, B, C as follows: Partner A receives 25% of the profit, Partner B receives 50% of the profit, Partner C receives 25% of the profit.

Would it be better to form the company as an LLC or an S Corp to reduce tax liability? The company is formed in Florida, which has no state income tax.

If needed, salary of Partner A could be reduced to $74,900 (top limit of 15% tax bracket for married filing jointly) for years 2015 & 2016 if it would make a significant difference on 2016 tax liability.

Answer 1

This is actually quite a complicated issue. I suggest you talk to a properly licensed tax adviser (EA/CPA licensed in your State). Legal advice (from an attorney licensed in your State) is also highly recommended.

There are many issues at hand here.

1. Income - both types of entities are pass-through, so "earnings" are taxed the same. However, for S-Corp there's a "reasonable compensation" requirement, so while B and C don't do any "work" they may be required to draw salary as executives/directors (if they act as such).

2. Equity - for S-Corp you cannot have different classes of shares, all are the same. So you cannot have 2 partners contribute money and third to contribute nothing (work is compensated, you'll be getting salary) and all three have the same stake in the company. You can have that with an LLC.

3. Expansion - S-Corp is limited to X shareholders, all of which have to be Americans. Once you get a foreign partner, or more than 100 partners - you automatically become C-Corp whether you want it or not.

4. Investors - it would be very hard for you to find external investors if you're a LLC.

There are many more things to consider. Do not make this decision lightly. Fixing things is usually much more expensive than doing them right at the first place.

Answer 2

An LLC or an S corp will result in the same tax obligations because both are pass-through tax entities.

An LLC is more flexible for the situation you describe because the member and manager responsibilities can be detailed in the operating agreement. You really should get a business attorney to help you get your operating agreement in order. There's also a startups beta site on Stack Exchange that may be able to help you with questions about ways to handle your operating agreement.