Ohio Practical Business Lawyer & Attorney : Teri Rasmussen : Lane Alton & Horst Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

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I have written before about the various factors one should consider in choosing a legal entity for your business.  Click here and here for my past posts on the subject.  Like many others, I have ultimately suggested that the choice in many cases comes down to a limited liability company and a corporation.  But which one?  For some clients, the balance sometimes seems to tip towards an S-corporation by the prospect of perhaps saving on the payment of self-employment payroll taxes - something which may or may not come to fruition. 

Not being an accountant, I have generally been content to let my client's CPA influence the choice of entity decision in this direction.  Recently, however, I decided to actually look into this and learned that this touted benefit may be illusory for all but single shareholder corporations.  Why?  Well, basically because the Internal Revenue Service has issued no clear regulations and, however payments to owners are nominally characterized, overly aggressive taxpayers are likely to be penalized.  For an in-depth and fairly technical analysis of the issue,as well as one possible sophisticated "work -around" click here.

Many people believe that they can avoid self-employment tax by calling payments to owners in S-corporations "dividends" rather than wages or salary compensation.  However, shareholders must still be able to justify and substantiate the amount paid as salary as constituting "reasonable compensation".  This means that shareholders paying themselves only a very miniscule amount as salary are running a significant risk that if audited, the overly large amounts paid as dividends are likely to be recharacterized as compensation for which self-employment tax should have been paid.  This is particularly true for professionals, service companies, consultants and sales companies in which it is difficult to demonstrate that money paid is for anything other than the performance of services on behalf of the company.  

Bizpointers:  Here's some basic pointers to keep in mind when analyzing the purported self-employment tax savings and what it really means:

• If earnings will be retained within the company and used to expand and grow the business rather than distributed to the owners, these amounts are less likely to be subject to self-employment tax if the corporate form is used than if an LLC is utilized. 

• The one situation in which tax planning may strongly indicate use of a corporation rather than an LLC is where there is, and probably will continue to be, a single owner.  In these cases, an LLC cannot be used to limit self-employment taxes because it is automatically characterized as a disregarded entity.  

• There is no magic test for what counts as "reasonable compensation".  Obviously, industry standards, profitability level of the business,  and what non-owner employees performing similar services in the company are paid can help support the "reasonableness" of particular owner compensation.

• LLC members (as well as corporation shareholders) may be able to mitigate some of the effect of self employment tax by having the business lease real or personal property from the owners, which would be a deductible business expense for the company while representing cash flow and income to the owner.

• Payments to inactive LLC members not participating in the day to day operation of the business (and not designated as managers) should generally not be subject to self-employment tax.

There are many factors that must be considered in choosing the appropriate form of legal entity for a particular business.  Consulation with professional advisors such as CPAs and business attorneys can result in helpful advice in evaluating the relative importance of those factors in specific contexts.