My very brief summation of the tax attributes of the various legal entity forms of doing business is as follows:
Sole proprietorship: All income is reported on schedule C of your personal return. Net business income is also subject to 15.3% self-employment tax (with ceiling limitations).
LLC: Separate legal entity. For federal tax purposes, it is treated as a sole proprietorship if it has one owner or a partnership if it has more than one owner. An election can be made to be taxed as a C corp or as a S corp rather than as a sole proprietorship or partnership. State taxation varies among states.
Corporation: Separate legal entity recognized for tax purposes. Generally corporations are referred to as C corps unless an S corp election is made. With a C corp, taxes are paid at the corporate level on their net income. Corporations can deduct salaries and wages paid from their income (You report your personal salaries/wages as income on your personal return). Corporations pay 7.65% FICA taxes and withhold an additional 7.65% FICA taxes on salaries/wages paid (subject to ceilings). Any additional monies/property paid to you (in excess of salary/wages) will be taxed to you personally as dividends (double taxation) provided the C corp has accumulated earnings and profits.
C corps and LLCs that elect to be treated as S corps generally avoid this double taxation at the personal level on dividend payments, since S corps (as well as partnerships) are considered "flow thru" entities for tax purposes. Therefore, a shareholder or member's individual tax return will show his respective share of the net income of the business and the salaries/wages paid to him. Note: not all states recognize S corp status for state tax purposes.
One advantage of S corp status (for either electing C corps or LLC's) is the ability to avoid excessive self-employment or FICA taxes. As long as you are paying yourself a "reasonable" wage or salary, any remaining income distributions are not subject to SE or FICA taxes.
It may, in some situations, be preferable to be taxed as a C corp. Talking in general terms, this may occur when you plan on reinvesting corporate profits in the business rather that taking them out as dividends. In such case (depending on the income levels) you may be able to take advantage of the lower C corp tax rates.
Electing how LLC's are taxed: Form 8832
S corp election: Form 2553
IRS publications and forms:
http://www.irs.gov/businesses/index.html
Also, if you want to know what the IRS looks for when auditing your internet business, see this article:
http://www.ibls.com/internet_law_news_portal_view.aspx?s=latestnews&id=1745
Hope this helps.
