You've decided to open your business and now you're facing the daunting task of structuring it as a corporation. Many entrepreneurs opt to form limited liability companies or an LLC.
Currently, every state, including the District of Columbia, allows single-owner LLCs. To create an LLC, you’ll need to file the proper documents with the appropriate state agency and pay filing fees. But before you make a decision on a corporate structure, you should first understand the tax implications of an LLC.
The Structure of an LLC
LLCs shield the personal assets of their owners. This means that if your company has bad debts, banks and other lenders cannot seize your personal property. The only exception is if you signed a personal guarantee to finance your business. Your LLC protects your assets as a corporate structure does, but an LLC has more management flexibility and taxes are often simpler.
The tax implications of an LLC differ from those of corporations. LLCs use "pass-through taxation," which means the LLC does not pay taxes. Income from the business is instead passed down to the company's owners, who are called members in LLCs. They claim the profits or losses on their personal tax forms.
Single-owner LLCs pay taxes on Form1040 with the Internal Revenue Service (IRS). Partnership LLCs, in which there is more than one owner, must file partnership returns using Form 1065. Both of these are simpler than paying taxes through a corporate structure. Using these returns also avoids double taxation, under which corporations pay taxes on their income and shareholders also pay taxes when the corporation's profits are distributed to them through dividends. Because an LLC does not have shareholders, it has a different tax structure.
For example, if a company earns under $50,000, its corporate tax rate is 15 percent. LLC owners would have to pay much higher tax rates--$4,386 plus 25 percent of the amount over $31,850--for the same income on their 1040 tax forms. That said, however, if those earnings are passed on to the shareholders of a corporation as dividends, the shareholder will have to pay a 15 percent tax on those dividends as well.
But LLC's can elect to be treated as a corporation for tax purposes by filing Form 8832 with the IRS. That means an LLC can take advantage of lower tax rates without having to change its corporate structure.
Taxing the Losses of an LLC
The tax implications of an LLC are not as beneficial when it comes to losses. You may not be able to deduct all losses for your business because you have chosen to limit your personal liability in the company.
Check the tax implications of a limited liability company in your state; many states charge additional taxes and fees on LLCs. The fee is often an annual flat tax. California, for example, charges two separate fees for LLC's registered in the state if they earn more than $250,000.
It's important for owners of small businesses to closely follow tax developments on the federal and state levels with the potential to affect the tax treatment of their particular business entity, including the LLC.