You've taken the plunge and created your own business. Now you need to figure out, for U.S. tax purposes, in which legal form it will operate. The main types from which to choose are a sole proprietorship, general partnership, limited liability company (LLC), C corporation and S corporation. One of the most popular choices from this group is the LLC.
Many business owners favor LLCs, created by a state filing, because they're easy to operate. A more intimate type of business set-up than a corporation, all of an LLC's profits and losses are reported on the owner(s) personal tax returns; the LLC itself doesn't pay federal or state income taxes. A corporation, in contrast, is a separate tax entity from its owner(s) and pays taxes. Because an LLC's profits and losses are run through the owners' tax returns, the Internal Revenue Service (IRS) calls LLCs pass-through entities. The IRS also uses this term for partnerships and sole proprietorships.
LLCs are also popular because they shield business owners from being personally liable for business debts. If your LLC incurs debt, only its assets can be used for repayment. (Of course, this is assuming you haven't personally guaranteed something -- say, an equipment purchase or lease.) Another LLC benefit? If you co-own an LLC and your partner becomes saddled with personal debt, his creditors won't be able to touch the business [source: Bradie, Bradie and Bradie].
Many LLC owners are self-employed, so no taxes are withheld from their income. Tax law requires they make quarterly estimated-tax payments to the IRS and their state. Quarterly self-employment taxes to cover Medicare and Social Security must also be paid. The one exception to the self-employment tax rule comes if a member of a multi-owner LLC is merely an investor who doesn't provide any services or make any decisions. In some cases, this person may be exempt from the tax [source: Beesley].
A final point to keep in mind is that some states charge LLCs an annual tax on earned income that's in addition to the income tax you pay on your personal return. Others levy an annual LLC fee (aka a franchise tax, registration fee or renewal fee), typically about $100. These fees aren't related to the LLC's income [sources: Beesley, Laurence].
Think an LLC is for you? Let's look at the various forms it can take.
Single-member vs. Multi-member LLCs
If you're the sole owner of your LLC, the IRS will consider it a disregarded entity and you'll report all profits and losses on a Schedule C tax form ("Profit or Loss from Business"), which you'll submit with your 1040 form. If your business is providing a service or selling a product, you'll also pay self-employment taxes on any profits using Schedule SE ("Self-Employment Tax"). However, if your company is involved in a passive business (e.g., rental activity), no self-employment taxes need to be paid. Instead, you'll report profits via Schedule E ("Supplemental Income and Loss"). Note that should you decide to leave some of your business' profits in the bank at the end of the year (e.g., to cover future expenses or for growth), you'll still have to pay income tax on that money.
Does your new business have two or more owners? Then the IRS will automatically classify it as a multi-member LLC, or partnership, for federal income tax purposes. As with a single-member LLC, your LLC won't pay taxes. Instead, each owner will pay a portion of the LLC's taxes on her personal income tax return. The amount of taxes each member pays is generally in proportion to her interest in the business. So if Molly owns 40 percent of the company, Maura owns 30 percent and Ella owns 30 percent, Molly gets 40 percent of the LLC's profits and is responsible for 40 percent of its losses, while the corresponding share for the other two is 30 percent. It's possible to split up the profits and losses differently; to do so, however, you'll need to request a "special allocation" from the IRS. As is the case with single-owner LLCs, you must pay taxes on your share of the profits annually, even if you leave your money in the bank [sources: Beesley, Laurence].
A final note. Although your multi-member LLC doesn't pay taxes, the partnership must file a Form 1065 ("U.S. Return of Partnership Income"). This informational document lets the IRS check and make sure each owner is reporting her income properly. Correspondingly, each LLC owner must attach Schedule K-1 ("Partner's Share of Income, Deductions, Credits, etc.") to her Form 1040,which shows her share of the LLC's profits and losses [source: Beesley].
LLCs As C Corporations
It's often preferable to have your multi-owner LLC treated as a C corporation for tax purposes. It can save you big bucks, which means you can use more of your profits to reinvest in your company and its growth. Unlike regular LLCs, corporations are considered by the IRS to be separate tax entities from the owners. Thus, a C corporation pays its own federal and state taxes; the money is not run through the owners' individual income taxes. This means business owners are not subject to self-employment taxes, which can be a great savings.
In addition, C corporation profits can be distributed in cash to owners as dividends or W-2 wages (money earned from an employer), assuming the person is performing legitimate, business-related work. W-2 wages are generally the preferred method, since the recipient is only taxed once on his wages. Dividends, however, are double-taxed; they're taxed first as part of the LLC's corporate income, and then again on the owner/shareholder's income tax return when they're handed out. So it's helpful that a C corporation can pay out some of its profits via wages [sources: Akalp, Entrepreneur].
Until 2017 in the U.S., tax law stipulated that the first $50,000 of an LLC's profits be taxed at the beginning federal corporate tax rate of 15 percent. The rates then increased depending on the amount of profits, all the way up to a tax rate of 35 percent. However, thanks to the Tax Cuts and Jobs Act (TCJA) of 2017, starting with tax year 2018, all corporations are taxed at a flat rate of 21 percent [source: Murray].
The TCJA also created a new tax deduction for pass-through entities, equal to 20 percent of the new income from the entity. It phases out at $157,500 for single people and $315,00 for married people and ends once business income is over $207,500 for singles and $415,000 for marrieds [source: Fishman].
Let's look at one scenario to see the tax difference between operating as a C corporation and as a pass-through entity. Ed and Bob own a graphic design LLC that earns a profit of $75,000. They each own 50 percent of the business. If their company is operating as a multi-owner LLC, or partnership (these are pass-through entities), they would each record $30,000 on their personal income taxes, assuming they could each take the full 20 percent deduction. If they both filed as single people, they'd each owe $3,406 according to year 2019 tax rates (10 percent income tax rate for the first $9,700 and 12 percent on the remaining income), plus 15.3 percent in self-employment taxes ($5,737.50), for a total of $9,143.5 apiece and $18,287 together. That would leave $56,713 of their firm's profits for reinvestment [sources: IRS].
If Ed and Bob operated their business as an LLC functioning as a C corporation, however, no profits would be run through their personal income taxes, and so no self-employment taxes would be levied. Instead, their profits would be taxed at the corporate tax rate of 21 percent. This would result in a tax bill of $15,750, leaving $59,250 for reinvestment [source: Internal Revenue Service]. This example assumes Ed and Bob are leaving all profits in the corporation and not taking any out as W-2 wages or dividends. If they did take some profits as wages or dividends, they'd still have to pay income tax on that.
Of course, how much an LLC earns and how much the owners take for salary could change the direction of these figures and determine which tax structure is better.
LLCs As S Corporations
Your final option for operating your LLC is to run it as an S corporation, which you can do if your business has multiple owners/shareholders, although not more than 100. An S corporation is sort of a combination of a corporation and pass-through entity, as no corporate income taxes are levied on the LLC's profits, yet no self-employment taxes are, either. Running your LLC as an S corporation is generally a good option if you and your co-owners intend to take some or all of the profits out of the business [sources: Dahl, Entrepreneur]. Here's how it works.
Like LLCs-as-C-corporations, LLCs-as-S-corporations can make cash payments to owners via wages or dividends. Any wages or salaries paid must be fair -- e.g., the industry standard -- and not an amount artificially high or low. The LLC is also responsible for FICA (Federal Insurance Contributions Act) taxes, such as Medicare and Social Security and other withholding requirements.
At year's end, any cash profits that aren't paid out via wages and salaries are then parceled out equally to owner/shareholders as dividends. The dividends are considered passive dividend income, and are taxed on the co-owners' individual income tax returns at a lower rate than their income is. If the business registers a loss, each co-owner would include her share of the loss on her individual income tax returns. The LLC then files an 1120S tax return (U.S. Income Tax Return for an S Corporation) [sources: BizFilings, Dahl].
One final point about LLCs as S corporations, which is also true for LLCs as C corporations, is that they can issue stock options and ownership plans, which may be beneficial. But tax law also requires both types of corporations to follow more procedures, such as creating bylaws, holding formal board meetings, taking accurate minutes and so forth.
Taxes are never a simple issue, nor is determining the best structure for your business. If you think forming an LLC will save you money, consult with an expert such as your accountant, who will be able to help guide you.
Originally Published: Dec 18, 2014
Author's Note: How LLC Taxes Work
As a self-employed writer married to an accountant, I let my hubby figure out how I should file my taxes. He went with sole proprietorship, but now I'm wondering if I should create an LLC. We'll have to revisit this issue.
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