Wednesday, January 8, 2014

Tax implications for an LLC?

Should my business be an LLC.  My mechanic told me there are unbelievable tax benefits for an LLC. With all due respect to mechanics, pilots, plumbers, money management bloggers, etc., it is in your best interest to get your information from experts in the field.  When an LLC is recommended for tax purposes realize that the IRS does not have a tax return for an LLC.  There are tax returns for sole proprietors, partnerships, S-Corporations and C-Corporations but none for LLCs.  How can that be?  Since the IRS does not recognize an LLC as a tax entity when you form an LLC you have to choose how that LLC will be treated for Federal income tax purposes.  So you can choose to have your LLC treated as a sole proprietor (if it is a single member LLC), as a partnership (if the LLC has more than one member), as an S-Corporation or C-Corporation.

What tax benefit comes from your business being an LLC depends on the tax status you choose.  What type of tax treatment you should choose for your LLC depends on your situation.  Here I will consider the tax implications of choosing these various entities.

Sole Proprietor:

If you are just starting out in business for yourself you may want to choose to be treated as a sole proprietor.  A sole proprietor is the simplest entity form and typically requires less reporting with the IRS.  A sole proprietor reports his business income and expenses on his personal return typically on a schedule C.  The net income on the schedule C is typically subject to both income taxes and self employment taxes.  Self Employment taxes run about 15% of the net income and are similar to the Social Security and Medicare taxes withheld from an employee.  The only thing is the Social Security and Medicare withheld from an employee's paycheck is typically matched by the employer.  For a self employed individual you are basically paying both halves.


You may be able to choose to have your LLC taxed as a Partnership if the LLC has more than one member.  A Partnership will file it's own separate tax return but in most cases the Partnership is not subject to income taxes but the partners' share of the profits will then be reported on each partner's personal tax return.  In most cases the profits from the partnership will, like a sole proprietorship, be subject to both income taxes and the self-employment tax on the individual partners tax returns if the partner has active participation in the partnership.  So if you actively participate in the partnership the tax situation is similar to a sole proprietor except a separate tax return has to be prepared for the partnership.


If you have less than 100 members in your LLC you may be able to elect to have it treated as an S-Corporation.  There can be tax advantages to being treated as an S-Corporation and there is also more responsibility with an S-Corporation.  An S-Corporation will also file a separate tax return and it is not subject to income taxes but each shareholder will then report his share of the profits on his personal income tax return.  In addition an S-Corporation is required to pay its active shareholders a reasonable salary.  So why would you choose to have your LLC treated as an S-Corporation?  The profits after salaries will be reported to the individual shareholders and these profits are reported on their individual returns and subject only to the income tax.  The employment taxes are only paid on the salaries paid to the shareholders.  This can result in a sizable tax savings compared to a sole proprietor or a partnership.  However, in addition to separate tax return for the S-Corporation, there will also be payroll to process and payroll tax returns to file and employment reporting to the state and unemployment taxes at both the state and federal level.  Make no mistake about it, the choice to be treated as an S-Corporation adds a level of complexity.


Finally, you may be able to elect to have your LLC treated as a C-Corporation.  The C-Corporation will also be required to file a separate tax return and its profits are subject to income taxes.  The C-Corporation however is not required to pay its shareholders a salary.  However, you can have a double taxation situation with a C-Corporation as eventually the profits have to be paid out to the shareholders as dividends and then they are also taxable to the individual shareholders.

Often C-Corporations are setup for liability protection or some anonymity for the shareholders and a separate S-Corporation is setup as a management company and the profits are run through the S-Corporation to the shareholders.  There are also other complex tax and liability strategies available with different entity combinations.

So should your business be structured as an LLC?  That depends on many factors.  In addition to tax matters you will want to consider your need to protect your personal assets from your business losses and liabilities.  Also, retirement planning can play a significant role in determining which entity or entities are best for you.  It is not unusual for business owners to run their business through more than one entity for protection, tax, and retirement planning purposes.  So consult with your CPA, lawyer and financial planner before you make the very important decision about how to structure your business(es).  Lawyer's tell me they love when you try to form an entity on your own or through a cheap online program because you will eventually wind up paying them handsomely to cleanup the errors.  So don't go the cheap way early on and undermine your ability to achieve great success over time. 

This is a general overview of the tax situation for different entities.  In reality there are various circumstances that can make this very complicate.  Again, it is best to have discussions with your CPA and attorney to get the information you need to make a wise choice for your situation.  This can be a complex tax situation that requires planning and ideally an ongoing knowledge of your situation.  I would be happy to assist you with this as your CPA and discuss different business and tax strategies with you.  Feel free to contact me using the information below.

Jeff Haywood, CPA
The CPA Superhero
The above information is general information and is not all inclusive and as always in your tax situation everything "depends on facts and circumstances."  So call me to talk about your specific facts and circumstances.