Tennessee Entity Selection: LLC v. S-Corp
Should I form my new business as a S-Corp or LLC? This important decision depends on a number of factors including what jurisdictions the entity will be legally formed and operate in and what states the entity owner(s) reside in.
Let’s take a quick look at the opportunities and detriments of both entity types in Tennessee.
In general, Tennessee LLC’s are more flexible entities than S-Corporations. The Tennessee Revised Limited Liability Company Act permits LLC’s to be organized with an almost endless variety of components. There is a short list of mandatory, statutory requirements, but otherwise the members may construct the LLC as they prefer. However, the Tennessee Business-Corporation Act is more rigid and set. There are fewer options regarding corporate structure. An S-Corporation has a board of directors, officers, and shareholders, whereas LLC’s have a variety of possible management structures. An LLC may be member managed, manager managed, or director managed, depending on how the organizers and members prefer to run the company.
LLC’s are treated as partnerships with pass-through taxation, but they have the option to elect to be treated as corporations for tax purposes. S-Corporations also have pass-through taxation; however, S-Corporations have many guidelines. S-Corporations are limited in the number and type of shareholders they may have, there can only be one class of stock, and they have the most unstable tax classification because if they commit one error, they will be reclassified by the IRS as C-Corporations and be subject to double taxation.
For some S-Corporations there may be certain tax advantages not available to LLC’s. Instead of paying shareholders who are active in the business a salary, S-Corporations oftentimes withhold a salary and instead pay a dividend to those shareholders who are active in the business. Theoretically, as long as this practice is not challenged by the IRS this can reduce the amount of self-employment tax due and payable. If, however, the IRS challenges such a practice and it is shown that the shareholder is actively engaged in the business, then dividends will be characterized as compensation and back self-employment taxes and penalties may be assessed. The IRS has traditionally taken a closer look at S-Corporations since the potential for abuse is so large.
For Tennessee S-Corporations and Tennessee resident shareholders, any potential tax savings is offset because Tennessee S-Corporations are subject to franchise and excise tax ($2,500 per million dollars of entity value plus 6.5% of net income earned by the entity). While a Tennessee LLC must annually file a franchise and excise tax return, if a professional is active in the business most if not all of their income will be deductible so generally little or no franchise and excise tax will be owed.
Additionally, resident shareholders are subject to the Hall income tax. Therefore, the effective tax rate for Tennessee S-Corporations created to avoid self-employment tax is similar to an LLC. More importantly, by not paying self-employment taxes, Tennessee S-Corporation shareholders do not get the advantage of buying into Social Security and Medicare even though they are subject to a similar effective tax rate.
Choosing the structure of your business entity is an important decision. Before making that decision, you should understand the unique characteristics of the entity and consider this knowledge in conjunction with the goals and objectives of your business venture.
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