Q. I am currently a sole proprietor, but will soon need liability protection as an LLC or an S Corp. Legally, I can go either way, but from a tax standpoint, which would you recommend? I would like to pass half of my income to my wife to avoid Self-Employment Tax. I understand that if she is an inactive member/shareholder, we can divert half of the net income of the enterprise to her and thereby avoid the Self-Employment Tax. Is this true?

A: Your question can be a very complicated issue and certainly involves more than just federal taxation. I would encourage you to consult your personal tax and legal advisors to make sure that your personal facts and circumstances are properly reviewed.

My personal opinion is that the S corporation form of organization is outdated and is no longer necessary since the inception of LLCs. The S corporation owner attribution rules can be cumbersome. The original S corporation was designed to provide liability protection and afford pass-through taxation to owners. All of these things can be accomplished with the LLC. Therefore, from a tax standpointrelated to "pass through taxation" both forms of organization are effective. I believe that the LLC form of organization is easier to establish and the cumbersome owner attribution rules are not applicable. I therefore believe the LLC form of organization is preferrable to the S corporation.

Under the LLC form of organization, you could choose partnership taxation for federal purposes and if your wife does not actively participate in the business, then her earnings from the business would not be subject to the SE tax. Again, this can be a complicated topic and if your wife does indeed contribute services to the business, she should certainly be compensated for her service and the appropriate self-employment tax should be paid.

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