Tax Tip: Become an LLC

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Are you thinking about starting your own business? One of the most important decisions facing you is what form of business organization to choose. This choice will determine how your business will be taxed and the amount and type of paperwork and reporting that will be required.

You can choose to organize your business as a sole proprietorship, a partnership, a “C” corporation, an “S” corporation or a Limited Liability Corporation.

This article will discuss in detail the Limited Liability Company, or LLC, the new entity of choice for both experienced entrepreneurs and new startups. I will explain what an LLC is, why it is right for you, how to form one and how to operate as an LLC.

What is an LLC?

A Limited Liability Company is a legal form of business organization that combines the flexibility and ease of filing of a partnership or sole proprietorship with the limited liability protection of a corporation.

The LLC has been popular in Europe since it was first created by German law in 1892, but was not used in the U.S. until 1977, when Wyoming was the first state to enact LLC legislation. In 1988, the IRS agreed that an LLC would be taxed as a partnership, and allowed “pass-thru” status. All 50 states now have LLC acts.

Instead of stockholders or partners, an LLC has members who have basically the same rights and responsibilities as stockholders or partners.

What Does an LLC Do for You?

Perhaps the most important thing an LLC can do for a small business is to provide its owner or owners with a greater level of protection.  In most cases, the creditors of an LLC can’t take the personal assets of the owners to satisfy the debts or obligations of the LLC.

Limited liability means that a business owner’s personal financial liability is limited to the owner’s investment or equity in the business.  If a company whose owners have limited liability is sued, it is the company that is being sued and not the owners.

The example I have always used to explain limited liability concerns a business like my tax practice. I once operated out of a storefront office. If a client tripped in my office, broke his leg and sued the business the most he could get, beyond any insurance coverage, would be the specific assets of the business — cash, furniture and equipment. The client could not go after my personal bank accounts, home, car or first-born to satisfy any legal judgment.

If I defaulted on a business loan or credit card, the bank or vendor could again only go after the specific assets of the business and not my personal property.

As with any law, there are exceptions. The client could allege that I purposely tripped him and sue me individually as well.  Or as the owner of a new business I may be required to personally guarantee the loans and debts of the business.  There is really no way to get full, guaranteed liability protection in all situations — but the LLC is an excellent way to get a great deal of it at the least amount of expense.

Who Should Form an LLC?

Every small business, even those that might not have elected to incorporate in the past, should seriously consider organizing as an LLC.  It is easy and inexpensive to form and maintain.

The bigger and more involved or complicated the business operation the greater the likelihood that it should incorporate rather than forming an LLC.

If you own a rental property it is a good idea to put the title of the property in an LLC. If you own more than one rental property, you can have a separate LLC for each property.

Tax Considerations

A Limited Liability Corporation has the option of being taxed as either a corporation or the “default” pass-through entity.

The “default” for a one-member LLC business operation is a Sole Proprietorship, reporting income and expenses on Schedule C of the owner’s Form 1040.  If the one-member LLC is a rental activity, income and expenses are reported on Schedule E.  A one-member LLC does not have to file a separate business tax return.

The default entity for an LLC with more than one member is a Partnership, which files IRS Form 1065, with income, losses, deductions and credits being “passed through” to the members on a Form K-1. The specific information reported on the partner’s Form K-1 is reported on the partner’s Form 1040. The Form 1065 is an “information return” only. A partnership filing a Form 1065 does not pay income tax on its profits, but rather each individual partner pays income tax on his Form 1040 on his or her share of the partnership profits.

A loss from the LLC taxed as the default entity, whether reported on Schedule C or passed through via Form K-1, can be deducted against other taxable income of the members, such as wages, interest, dividends and capital gains, to reduce Adjusted Gross Income. Losses from rental real estate owned by an LLC are subject to the special “passive activity rules” (to complicated to go into here). Any profit from the LLC, unless it is a rental activity, will be subject to the “self-employment tax,” 50% of which can be claimed as an “above-the-line” deduction on Page 1 of Form 1040.

An LLC that chooses to be taxed as a corporation makes the election by filing Form 8832 and must follow all the federal and state tax laws applicable to corporations.

There are two types of corporations — a regular “C” corporation and a “Sub-chapter S” corporation. An LLC can choose to be taxed as either a C or an S corporation.

A regular “C” corporation must file a separate income tax return — IRS Form 1120 — and pay income tax on its net profits. Losses from a “C” corporation stay witnin the corporation and may be carried forward, or back, to apply against future, or past, taxable income. The losses of a “C” corporation cannot be deducted on the individual income tax returns of its stockholders.

An “S” corporation allows for the income, deductions and credits of the corporation to be passed through to its shareholders — similar to the way in which partnership income, deductions and credits are passes through to the individual parthers. The corporation files a Form 1120S information return and issues each stockholder a Form K-1. However the “S” corporation has more rigid rules concerning allocating profits and losses to stockholders. Profits and losses must be passed to stockholders to the extent of their stock ownership. A taxpayer who ownes 40% of the “S” corporation stock reports 40% of profit, loss, and all other pass-through items. A partnership has more flexibility in allocating profits and losses to individual partners on the K-1.

Amounts paid by a corporation to its shareholders are treated as either dividends or wages.

Dividends paid by a “C” corporation are taxed twice — the stockholder pays tax on the dividends received on his/her Form 1040 and the corporation is not allowed a deduction for dividends paid, so any dividends paid are included in the corporation’s taxable income. Wages paid by a corporation to a stockholder are subject to all federal and state payroll taxes.

While the profits of an LLC are subject to “self-employment tax”, they are not subject to federal unemployment tax (FUTA) or state unemployment or disability taxes. If the owner is the only employee of a corporation the business must file quarterly federal and state payroll tax returns. No separate payroll tax returns are required if an LLC taxed as the default has no employees other than the owners.

Operating as a corporation, wheter “C” or “S,” is much more expensive, involves substantially more paperwork and tax filings, and has a greater potential for “agita” than operating as a partnership or sole proprietorship.

It’s my belief that the reason for becoming an LLC is to be able to be taxed as the default entity. If you want to be taxed as a corporation you should form a corporation.

You should consult an experienced tax professional before deciding to form a corporation.  A corporation is not the most appropriate form of organization for many businesses.  While it may be relatively easy to form a corporation, it can be very expensive to maintain and to dissolve one.

The IRS will permit an LLC to change its election and go from being treated as a “default” entity to being taxes as a corporation, and visa versa.

How to Form an LLC?

Forming an LLC doesn’t necessarily require a lawyer’s help. You should be able to do it yourself very easily online at the website of your State (do a search for “business formation” on your State’s homepage). Each state will charge some kind of filing fees for forming an LLC, and may also charge the LLC a nominal “annual report” filing fee each year.

If your LLC will have more than one member, it is important to have a written operating agreement, similar to a general partnership agreement, which will outline the duties, rights and responsibilities of the members. For this, you may want to consult a lawyer to make sure all partners are properly protected under all scenarios and any “peculiarities” of your unique situation are covered.

An LLC operating as either a partnership or a corporation will need to apply for a federal Employer Identification Number.  A one-member LLC that is taxed as a sole proprietor does not need a federal ID number, unless it will have employees. The owner can use his or her Social Security number.

You can apply for a federal Employer Identification Number online at the IRS Web site. Go to www.irs.gov. Click on “Apply for an Employer Identification Number (EIN) Online” under “Online Services” in the left hand margin. There is no fee for applying for a federal Employer Identification Number online.

An LLC may also be required to register the business with its home state, which can be done for free online, again at your State’s Web site. This process is separate from and in addition to forming the LLC.

Keeping Your LLC Finances Straight

When setting up your business, keep in mind that, like a corporation, an LLC should be treated as a separate legal entity. Here are some things you should do:

  • Open a separate checking account in the name of the LLC.  Deposit all business income to this account and pay all business expenses from it.  Avoid using your personal checkbook for business activity and try not to pay personal bills from the business account.  If the balance in the LLC account is low, you can “loan” money to the business.  Reimburse yourself for cash payments, automobile use and home office use, and pay yourself a “drawing” by writing a check from the LLC account.
  • All business leases for office or storage space and equipment should be in the name of the LLC, as well as all business insurance policies (i.e. liability, office overhead, workers’ compensation).
  • All store credit card accounts for business purchases should be in the name of the LLC (i.e. Staples, Office Max or Office Depot). Have a bank or American Express credit card in the name of the LLC and use it exclusively for business purposes.
  • The name of the LLC should appear on all business stationery, letterhead, billhead, business forms and applications.
  • The LLC should hold “title” to all business equipment, copyrights and trademarks. If you own real property for the business, such as an office building or storage facility, have title held by a separate LLC. In the case of rental property, the title should be in the name of the LLC.

If you have any questions about forming or operating a Limited Liability Company, or any other form of business organization, you should consult a tax professional.

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