shareholder level with limited liability for the shareholder. An S corporation has the same corporate characteristics as a C (taxpaying) corporation. The only difference is that an election has been filed with the IRS for the corporation to be treated differently for federal tax purposes. The election generally permits the income and losses of the S corporation to be reported directly on the shareholder's Form 1040, thereby eliminating any tax at the corporate level.
The drawback to forming an S corporation is that it requires you to file a separate corporate tax return along with your personal return, and the tax rules for S corporations are pretty tricky. Because of the added return preparation fees, tax accountants drool over clients with S corporations. You should hire one with plenty of experience — not with drooling, but in dealing with S corporations. An even better idea though, might be not to form an S corporation at all, but to form a limited liability company (LLC).
An LLC offers the same limited liability as an S corporation, but has the additional advantage to a sole owner of uncomplicated tax compliance rules. The LLC is a fairly recent phenomenon in the United States. It is an organization formed under state law to provide limited liability for its owners, who are called members, in the same way corporate shareholders are protected. An LLC is not a corporation under state law, however, which has caused uncertainty about its federal tax status. Beginning in 1997, the IRS adopted the simple approach of allowing most LLCs the choice of whether they will be taxed as a corporation or not. An LLC with at least two members is automatically treated as a partnership for tax purposes, and a single member LLC is treated as a sole proprietorship, unless a form is filed with the IRS electing to be taxed as a corporation. That means a sole proprietor who forms an LLC has what is called a "disregarded entity," or "tax nothing," and simply files Schedule C along with Form 1040, exactly the same way it was done before becoming an LLC.
The primary drawback for sole proprietors forming LLCs has been, until very recently, state laws regarding single member LLCs. Most states now allow single member LLCs and conform to the federal tax treatment, but check with your state department of revenue for the latest information. Several states charge LLCs annual entity level taxes, such as California where federal tax classification is honored, but there is an annual minimum franchise tax of $800 and a maximum gross receipts tax of $4,500.
In Minnesota, single member LLCs have been allowed since August 1, 1997. The federal classification rules are followed and there is no annual registration fee. The fee for organizing an LLC in Minnesota is $135. You can get a free copy of the Articles of Organization form and other information by calling the Secretary of State's office at (612) 296-2803.
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