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My partner and I have day jobs so we don't need to (or want to) draw salary from our startup. Our startup is already profitable but in our ideal world, the bank account associated with this startup would just accumulate money.

I realize this question is odd because most folks would be thrilled to draw salary from their startup, but we're trying to build enough capital to hire; our fundamental mission is teach tech skills and provide economic development in the economically-depressed area we live.

We just got organized as an LLC. What's the most tax-efficient structure for us? Should we opt to be treated like a default LLC or an 'S' Corp?

My preference is to hire and work with a tax professional to help us make these decision. Are there any recommendations?

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4 Answers

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We just got organized as an LLC...Should we opt to be treated like a default LLC or an 'S' Corp?

You might be a bit confused here. An LLC can elect to be taxed in one of two ways:

  1. Pass-Through taxation: In this case the LLC will be taxed like a partnership.
  2. Corporate taxation: In this case the LLC will be taxed like a C Corp.

So your choices are pass-through taxation or corporate taxation. An S Corp is a pass-through entity, so it is taxed like a partnership. By default, an LLC is taxed like a partnership (pass-through). So your question should really be, "Should we opt to be treated like a default LLC or a 'C' Corp?"

What's the most tax-efficient structure for us?

First, a little background for those that may not be familiar with these terms:

Pass-Through Taxation: The business profits and losses are passed through to the owners, and taxed at the owners' personal income tax rates. The taxation will occur even if no profits are distributed to the owners (i.e. all profits are left in the business bank account). For a bit more information on how pass-through taxation works, see this question Simple Overview of LLC Pass Through Taxation.

Corporate Taxation: The business is treated as a separate entity. As a result, the business will pay income taxes on profits at the corporate tax rate, which may be lower than the owner’s individual tax rate. On top of that, the owner will also have to pay income taxes on the portion of profits distributed to him, at his tax rate. This leads to the dreaded double taxation for the owner because he is paying taxes twice - once as personal tax, and once as corporate tax. This may sound bad, but there are cases where this may be the best choice. (There are also ways around this.)

So to answer your question, it depends. Generally speaking, from strictly an income tax point of view, I think startups with small profits tend to fare better with pass-through taxation (the default). However, there are many other factors involved in making this decision. You should definitely consult an accountant about your particular situation.

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An corporation with an S election offers pass through taxation. In california you are better off setting up an S corp because it costs the same. Also an S Corp can own other LLC's here, and LLC cannot own sub LLC's. Bottom line is, if you want to avoid paying taxes and bank up your profits you need to move the profit off books. You can do that using loans, or you can do it by having two companies that pass profit around like a soccer ball. Both will eventually catch up to you and likely bump you to the highest bracket. Make good use of your money by putting it into play. With the bad – Frank Dec 11 '10 at 23:07
economy there are some great plays out there in something as conservative as real estate. Will still be taxed, but at least your money will be growing in a rate a lot higher than ANY us bank can offer. – Frank Dec 11 '10 at 23:08
@Franky: Yes, I know that an S Corp offers pass-through taxation - I stated it in my answer :-) I don't think you understand the question. His business is already registered as an LLC. It is clearly stated in the question title, in the body of the question, and the question is tagged as such. So yes, an S Corp may offer certain advantages over other business structures, but it is totally irrelevant in this situation. The question here is which tax structure is best for his LLC (LLCs have the luxury of electing their tax structure). – Zuly Gonzalez♦ Dec 12 '10 at 4:52
up vote 1 down vote

in our ideal world, the bank account associated with this startup would just accumulate money

Hey look at that, we live in the same world :-)

Fact is, in either scenario, you will have to pay the same tax. And no matter how you do it, the tax will be on top of your day job's salary, which means that it'll be at whatever marginal rate you're at or approaching. And then you'll pay self-employment tax.

The only way to avoid self-employment tax is to pay yourself a salary (which has that same tax built in) and take distributions (which won't pay tax). But until it's a full-time job and your salary is remotely reasoanble, you can't do this.

If you do your own taxes now, then just buy the Premium version of Tax Cut (or whatever) and do it all yourself on Schedule C. It's not that hard to do.

Your best bet to avoid paying taxes is to spend the money. Buy what you'll need next year.

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in that ideal world we would not have cops and teachers because a guy like me would quickly turn every business he owns into a startup, every year. – Frank Dec 11 '10 at 23:05
up vote 0 down vote

Taxwise, there won't be a difference between choosing a pass-through LLC vs. S-Corp. Will you be offering some form of equity to your employees? If so, an LLC may be preferable because the S-Corp has a shareholder limit. I am not a tax lawyer though, so there may be other nuances involved like the self-employment tax that makes a C-corp more preferable. I would recommend consulting my colleague at http://www.naegelelaw.com/

EDIT: I've learned from Alex that member managed LLCs do not need to pay members salaries whereas are S-corps are required to.

The above is not legal advice nor does it constitute an attorney-client relationship.

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up vote 0 down vote

Both LLC and S Corp are taxed on their income. You cannot simply bank up your profits in a Bank account and have them not subject to USA tax.

There are some creative ways around this: 1. If you are a C Corp you can hold money (as long as you reasonably need to hold it), and it will be taxed at a max rate of 25%. This is a lot lower if you have a high profit business that needs to "bank up" for a few years.

  1. Another tax strategy would be to have 2 companies with different tax calendars ( you can set your own fiscal year) where profits are constantly converted to debts and moved from one company to another. This eseentially defers your tax liability for the future, but its greatly looked down upon.

  2. You could incorporate a new company offshore and bill your company for services there. You could let your money bank up in a more friendly jurisdiction such as Panama, Dubai or Ireland.

If you are making less than 500k per year, these strategies are a lot more work then they are worth. You probably need to rethink your strategy a bit.

Although its great to bank up and build a cushion, I often wonder what that money could be doing to spur further growth in your existing business? maybe you can save 10k per month, but would that 10k spent in marketing yield a profit of 25k in 12 months? You have to look at the big picture, not just tax avoidance. There is a lot more in play in business than the traditional grasshopper and ant theory on saving up.

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In your "2 companies" strategy, if by "greatly looked down upon" you mean "tax evasion" then yes, this is true. – Alex Papadimoulis Dec 10 '10 at 22:02
It actually is not tax evasion, but a very sleezy tax avoidance tactic. A lot of companies do this, this is how GE and others had literally 0 taxes this year. They shifted the tax liabilites to other companies offshore. Its not a smart way to proceed unless if you have tons of income that you need to deferr. Like I said, holding cash might be good, but it has its own costs. – Frank Dec 10 '10 at 22:05

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