Limited Liability Company
This legal structure has gained a lot of popularity in the recent years. A limited liability company (LLC) is a combined legal structure that provides features of a corporation and partnership. The limited liability protection of a corporation combined with the tax benefits & flexibility operating as a partnership is the key feature in Limited Liability Company.
In an LLC – limited liability Company, owners of an LLC are called as ‘Members’. If there is a single member, it’s called as a single member LLC. If there are multiple members, it’s called as a multi member LLC.
LLCs are not classified as a business entity for taxation. They need to file taxes as either C corporation, partnership, sole proprietor or S Corporation.
All profits and losses pass through at the member level. There is no taxation at LLC level. The Members then report profit or loss in their individual tax returns.
Advantages of an LLC
Pass through taxation – there is no double taxation. All profits or losses pass through the owners. Owners are then responsible to report taxes on their tax return.
Limited Liability. Liability is limited to the amount of investments of its members.
Relatively easy compliance as compared to a corporation. There is lesser paperwork to be maintained as part of corporate minutes etc. as compared to a corporation.
Sharing of Profits. Members can determine profit/loss % allocations either based on operating agreement or capital contributions.
Partnerships or corporations can be LLC members.
Can operate with a single member.
There is no limit on the number of members of LLC unless it is recognized as an S corporation.
Can be member managed or manager managed.
Most flexible business structures today as members can decide to operate various business areas through an operating agreement.
Disadvantages of an LLC
LLCs can be setup as C Corporation, partnership, sole proprietor or S Corporation. This can add complexity and the right entity tax classification may incur additional costs in understanding the tax implications by aggregate annual income.
Limited Life. In few states, once an LLC member dies/retires or leaves the LLC, the LLC may need to be dissolved and a new LLC may be required to be setup. This adds an additional layer of complexity and limited life.
Self-Employment Taxes. Members of an LLC need to pay self-employment taxes. The entire amount may be subject to tax.
How are LLCs taxed?
Single owner LLCs: If there only single member in an LLC, you will be treated as a sole proprietor. LLC does not pay any taxes but the profit or loss flows through the sole member’s tax returns. The sole member, in turn, files tax returns as part of an individual tax return.
You will file Form 1040 and Schedule C to report your business income or loss. You are required to pay taxes even if there is profit reinvested into the business. For this reason, many consider converting to a C Corporation.
IRS considers your business as a partnership if there are multiple members in your LLC. Profits or losses again flow through the partners’ tax returns. The partners then report their profit or loss on their tax return.
Most operating agreements required the members to allocate profit or losses based on their capital contribution. Eg: If you contribute 30% capital, then 30% of the profits of the business are allocated to you. However, it is not necessary to allocate based on capital contribution. The LLC can elect to allocate a different profit or loss allocation ratio to its partners via a special allocation.
You will file form 1065, the partnership will need to provide a form K-1. The partner, in turn, is required to report profit or loss from the partnership on their individual tax return.
LLC can elect to be taxed as a C Corporation, by filing the form 8832. If your business regularly needs to keep profits i.e. retained earnings, its most beneficial to elect C Corporation election. AS a C Corporation, the first $75,000 of corporate taxable income is lower than the individual income tax rates that apply to most businesses. This can save substantial amount of money that you may have otherwise paid in taxes. In addition, LLC can offer owners and employees various tax advantages stock options, ownership plans and tax advantaged fringe benefits.
As a C Corporation, you will file form 1120. Your company is taxed and recognized as a separate corporate entity. The shareholders are only taxed if they are distributed dividends. Therefore there is double taxation.
LLCs who elect to be taxed as an S Corporation: You will complete form 2553 within first 75 days of the financial year to be taxed as an S Corporation. You need to receive a confirmation letter from IRS. S Corporations have various limitations based on # of members, residency status etc. Therefore, you need to carefully choose this election if you think S Corporation may be the right option for you.
As an S Corporation, you are required to take a Salary as you will be considered an owner-employee. Eg: You earn $100,000 a year, you will need to determine a reasonable salary based on your tax situation eg:50,000. Please, however, note that there has been a lot of discussion around S corporation salary. Therefore, consult a qualified Certified public accountant who specializes in S Corporations.
In short, you will be paying:
Payroll taxes as an employee. As an employer, you will be filing all the required 940, 941s, W2s,1099s.
As an S Corporation, you do not have to pay medicare and social security taxes on your distributions. EG: If you have $100,000 annual income and you take $50,000 as salary. You pay $7,650 ($15.3% as taxes).
If you do not choose S Corporation taxes, you will incur additional Medicare ($1,450) and social security taxes ($626)
Because of this tax advantage, many LLCs now elect to be taxed as an S Corporation. Please note that you need to take salary otherwise there will be IRS scrutiny which in turn may lead to penalties and interest.
As an S Corporation, you will file form 1120 S and distribute K1 to the owner-employee
This combination has become very popular with Physician offices, Information technology consulting firms, freelancers & various small businesses.