The answer to this one is simple – it depends. Lots of variables here, and the form of entity that may be best for DC franchise tax reporting may not be best for federal income tax reporting. For many DC businesses, the question hinges on whether they meet the 80% personal services exemption since this exemption does not apply to corporations.
As a rule of thumb, if your business meets the 80% personal services test, operating as an LLC, Partnership or sole proprietorship will generally be better for DC franchise tax purposes. However, if your business does not meet the 80% test, operating as a corporation will generally be better for DC tax reporting as you can deduct 100% of owners compensation against DC taxable income, whereas you can only deduct 30% if you are an unincorporated entity.
What complicates this issue is you can’t easily flip flop between your choice of reporting entity each year, especially if you want to report as an S-Corp for federal income tax purposes. Additionally, your entity classification must be elected at the start of the year, so you can’t wait until year-end to determine what entity is best for you tax wise. Another key factor here is the owner(s) state(s) of residence. Good long-term tax planning is key here.