Question: I am considering starting a new business and I anticipate that it will produce losses, rather than profits for the first few years. Should I form a limited liability company or an S corporation to own and operate the business?

Answer: People ask this question of me a lot, but this question mixes the type of entity formed under state law with a method of federal taxation under the Internal Revenue Code of 1986, as amended. When you are thinking of forming an entity in California to operate a business or to own investment real property, the first question is what type of entity should I form under California law? More often than not the answer is a limited liability company.

After you form your company, the next question is what is the best method of income tax for the entity? If your tax advisor says that your LLC should be taxed as an S corporation and if it is eligible for that method of tax, then all of the members of company must sign an IRS Form 2553 (see the instructions) and file it with the Internal Revenue Service before the deadline for making the S corp election.

An LLC taxed as an S corporation is a “pass through” entity (it does not pay income taxes), which means that losses are passed through to the owners who can deduct the losses on their personal income tax returns (if they have sufficient basis).  Note: An LLC that elects to be taxed as a C corporation, an S corporation, a sole proprietorship or a partnership for federal income tax purposes does not change its character. The entity always remains an LLC created under California law regardless of the method of federal income tax applicable to the entity.

Bottom line: If S corp tax treatment is important and your business is in California, form a California LLC and cause it to be taxed as an S corporation by filing an IRS form 2553 in the first 75 days after forming the LLC.

P.S.  I recommend that everybody who forms an LLC consult with a good tax advisor as soon as possible after forming the entity to obtain advice on which of the four federal income tax methods (sole proprietorship, partnership, C corporation or S corporation) is best for the limited liability company. The election to change the default method of income tax (sole proprietorship or disregarded entity for a single member LLC or partnership for a multi-member LLC) must be filed within 75 days of the date of forming the LLC for the election to be effective from the date of formation.