As you start and grow your new business, how do you intend to structure it so that it efficiently operates and thrives? The most popular entity structure for a small business is the limited liability company (LLC).
1. Why forming an LLC
The following summarizes the benefits of forming an LLC:
1.1 Limited liability for owners:
LLC provides limited liability protection. When the LLC is being sued, the owners’ personal assets such as homes and savings are generally protected. A LLC provides a limit on the personal liability of its members similarly to how a corporation does. Typically, a member’s personal liability is limited to his or her investment in the LLC. The personal assets of the owners or members are separated from business debts and claims. Unlike a LLC, in a sole proprietorship or general partnership, each owner is liable for all of the debts of the business.
1.2 Pass-through of income to owners
LLCs are “pass-through” entities for tax purposes. The entity itself is not taxed, avoiding double taxation. Instead, net earnings of an LLC pass through to owners in the form of self-employment income subject to self-employment tax.
1.3 Operational flexibility
LLC is a less formal entity structure than corporations. They require fewer administrative tasks and less ongoing compliance requirements. Fewer formal meetings and record-keeping requirements may help reduce costs.
1.4 Fewer restrictions on profits distribution
Earnings don’t have to be distributed based on percentage of capital contributions. Members have more freedom to allocate profits or losses based on the operating agreement. There may be restrictions applied for S corporation elections.
1.5 Flexibility in accepting capital
The structure allows for more flexibility in accepting investments or entering into partnerships.
2. How is an LLC taxed?
If you form your business as an LLC, there are a few options for how you want your LLC to be taxed. For federal income tax purposes, an LLC can be taxed as one of the following: a sole proprietorship, a partnership, a C corporation or an S corporation.
2.1 Taxed as LLC
A single-member LLC is a disregarded entity and treated as a sole proprietorship. An LLC with more than one member is treated as partnerships and taxed under Subchapter K of the Internal Revenue Code.
2.2 Taxed as corporation
An LLC can elect to be taxed as a C corporation filing Form 8832, Entity Classification Election. Your LLC will be taxed under Subchapter C of the Code.
2.3 Taxed as S corporation
By filing Form 2553, Election by a Small Business Corporation, an LLC can elect to be taxed as an S corporation.
3. Benefit of S corporation election
3.1 Employment taxes
If you are an owner of a business taxed as a partnership and you are employed by the business, you’re considered an owner. If you are an owner of an entity taxed as an S corporation and you are employed by the business, you are considered as an employee. Wages paid to you are earned income subject to payroll tax. Net earnings that pass through to you and the other owners are considered dividend income and not subject to self-employment tax.
3.2 Possible qualified business income deduction
The Tax Cuts and Jobs Act gives pass-through entities a 20% “qualified business income” deduction. However, you should consult a tax expert regarding this matter as it can get more complex.
4. Benefits of the LLC entity taxed as S corporation
Establish your business as an LLC, but then make the election to have it treated as an S corporation by the IRS for tax purposes. You’ll have to make the special election with the IRS using Form 2553.
4.1 Your entity is an LLC
Your LLC will have the benefit of ease of administration which means fewer formal meetings and record-keeping requirements.
4.2 Your entity is taxed as S corporation
Your entity will have the pass-through of income, avoiding double taxation.
4.3 Your entity can pay you salaries
Your entity can pay wages or salaries to you and any other owners. This amount will be subject to payroll tax and withholding requirements. The net earnings can be distributed to you and the other owners as dividend income and not subject to self-employment tax.
5. Conclusion
Before registering your business you should carefully consider the pros and cons of different entity structure for your business operation and how it will be taxed. It is a wise practice to seek professional advice from a CPA or tax attorney when making important decisions like this.