Should I Create an LLC for My Small Business?
(Special note for this one….we are not attorneys. If you need legal advice about setting up an LLC or other business entity, contact an attorney. This information is simply for education and not legal nor tax advice for your specific business.)
We are often asked about LLCs. Usually, the question sounds something like “Would I pay fewer taxes if my small business were an LLC?”. Questions about LLCs and other business entity types are common because the topic is not easy to understand (especially for the less experienced entrepreneur or investor) and misinformation is plentiful. Here is a quick intro to LLCs to get you started on your journey.
LLC 101
Limited Liability Companies (LLC) are a popular choice of entity for small businesses and investment activities.
LLC owners are called “members.” The person designated to organize the legal and tax paperwork for the company is called the “managing member.”
Single-member LLCs have one owner (the managing member by default). Spouses who jointly own an LLC in a community property state can elect treatment as a single-member LLC for federal income tax purposes.
Multi-member LLCs have two or more members and can also be known as “Partnership LLCs.”
Key point: LLCs are not corporations. But LLCs can offer similar legal protection to their members (owners).
Keep reading to learn the most important things to know about LLCs.
LLCs Offer Legal Protection, Not Tax Savings
Using an LLC to conduct a business or investment activity generally protects your personal assets from LLC business-related liabilities — similar to the legal protection offered by a corporation.
As you know, liabilities and lawsuits can arise from simple things such as the FedEx guy slipping on the ice on your front steps, a customer who thinks you’ve done them wrong, or in seemingly endless and complicated ways if you have employees.
Key point: As a general rule, no type of entity (including an LLC) will protect your personal assets from exposure to liabilities related to your own professional malpractice, negligence, or tortious acts.
Tortious acts are wrongful deeds other than by breach of contract —such as the negligent operation of a motor vehicle, not salting the ice on your front steps, or not making a repair to a dangerous issue at a rental property resulting in property damage or injuries. The issue of liability protection offered by an LLC is a matter of state law. Seek advice from a competent business attorney for details.
Single-Member LLC Tax Basics
Single-member LLC businesses owned by individuals are treated as sole-proprietorships for federal (and state) income tax purposes unless you elect to treat the single-member LLC as a corporation. In other words, the default federal income tax treatment for a single-member LLC business is “sole-proprietorship status.” Under the default treatment, you simply report all the single-member LLC’s income and expenses on Schedule C of your personal tax return, just as you would have as a sole-proprietor. It is as though the IRS (and state) pretend like your LLC does not exist for tax purposes, which is why they call a single-member LLC a “disregarded entity.”
You read that right, there is no federal tax difference between sole-proprietor and LLC. If your state has income taxes, the state tax laws usually follow the IRS in this matter.
Sales and Service If the single-member LLC business activity generates net self-employment income from the Schedule C, you will report that on Schedule SE of your personal Form 1040.
Rentals If the single-member LLC activity is a rental activity, you report the rental income and expenses on Schedule E of your Form 1040.
Farm or Ranch You report the numbers for a farming or ranching activity on Schedule F.
Simple, right? You don’t need to file a separate federal income tax return for the single-member LLC because as far as taxes are concerned you are not separate from your business. And other things being equal, simple is good.
Three key points about single-member LLCs:
The big federal income tax advantage of operating as a single-member LLC is extreme simplicity in filing tax returns, not actual tax savings.
The big non-tax advantage is liability protection, under applicable state law.
As mentioned, you can elect to treat a single-member LLC as a corporation for federal and state income tax purposes, but we don’t always recommend that (see below).
Multi-member LLC Tax Basics
Multi-member LLCs are treated as Partnerships for federal and state income tax purposes…unless you elect to treat the LLC as a corporation. In other words, the default federal income tax treatment of a multi-member LLC is “Partnership Status.”
Under the default treatment, you must file an annual partnership federal income tax return on Form 1065.
From the Form 1065 partnership return, the LLC issues an annual Schedule K-1 to each member to report that member’s share of the LLC’s income and expenses. The member then takes those taxable and deductible amounts from the K-1 into account on the member’s own tax return (Form 1040 for a member who is an individual).
The multi-member LLC itself does not pay federal income tax. This arrangement is called “pass-through taxation,” because the income and expenses from the LLC’s operations are passed through to the members via the K-1 who then take them into account on their own returns. (The same pass-through taxation concept applies to entities set up as “regular” partnerships under applicable state law.) Multi-member LLCs are called “pass-through entities.”
Electing to Treat the LLC as a Corporation for Tax Purposes
You have the option of electing to treat a single-member LLC or multi-member LLC as a corporation for federal income tax purposes. Generally, you do that by filing IRS Form 8832, Entity Classification Election, to change the default classification of the single-member LLC or multi-member LLC to the new classification as a corporation. Again, generally, states follow the IRS in this tax status matter.
S Corp If your desire is to have your LLC treated as an S Corporation, it can elect S Corporation status directly using IRS Form 2553 within 75-days after the LLC is established. Or, if you miss that window of time, you can elect it on the first business S Corp tax return. Consult your tax professional before making this move as there is a lot more to this complex tax treatment.
C Corp You can elect C corporation treatment on Form 8832. After you elect C Corp treatment, if you wish, you may then subsequently elect S corporation treatment on IRS Form 2553. This gets quickly confusing and we suggest you consult a tax professional before doing this as well.
To LLC or Not to LLC?
You can probably tell already, this can be a complex question depending on the business. However, for many sole-proprietors, creating an LLC is a simple, inexpensive, and a legally protective step that is easily completed online or with the help of a local attorney. As long as the business owner understands what an LLC does and does not do for their business, creating an LLC will seem like a no-brainer for entrepreneurs looking for a business entity that fits their needs. It can be a very good way to begin.
A quick note to our real estate investor friends: If you are considering one or more LLCs for your investment properties, be very aware of the requirements involved in operating more than one LLC. Too few LLCs can bring legal heartaches, too many can cause administrative and bookkeeping headaches. A good rule of thumb is to only create as many LLCs as you can reasonably manage (hint: it’s probably not one LLC per property).
The question becomes more complex when, once the LLC is created, considering the tax status election of S or C Corporation for your LLC. While there may be valid non-tax reasons for electing to treat an LLC as a corporation, for many small-business owners with lower annual revenue, say less than $75K, we think tax reasons generally dictate against taking that step. If you are a sole-proprietor and you and your attorney are considering forming your LLC then immediately electing S Corp tax status for your LLC, you should strongly insist on (and be willing to pay for!!) a tax consultation with a knowledgeable CPA. Without understanding the full burden of all required administrative actions and costs involved in operating a corporation each year, you may be in for a big surprise come tax time. Many attorneys (and some not-so-knowledgeable CPAs) fail to mention that part when setting up your entity. We have seen many eager yet inexperienced entrepreneurs establish or elect corporation status for their small business only to pay far more in administrative effort and costs than any tax advantage would ever provide.
A quick note about issuing stock: For some, a large influence in the decision of a business entity is funding. If you and/or your investing partners plan to issue shares of stock at any point as a way to acquire funding for your business, an LLC might not be the right choice. Remember, only corporations can issue stock. LLCs, even those taxed as an S or C Corp, are not corporations in a legal sense, therefore, cannot issue stock. Ask your attorney about this aspect before locking in your decision to create an LLC.
Choosing the right business entity can be a very confusing topic that causes a small-business owner’s heads to ache. Our best overall recommendation is to speak to a business-savvy attorney and a qualified, knowledgeable tax professional before setting up an LLC or corporation.
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