An LLC is a business structure just like a corporation or a partnership. If you are a business owner, you can setup your own business in an LLC form, keeping the profits and losses separate. You can also set up a company in an LLC form if you want to carry on a business that is separate from the personal business of the people who own it.
For those who don’t know, an LLC (or limited liability company) is a type of business whose owners can claim limited liability for the company’s debts. The LLC is a partnership in which all members share equally in the profits of the business. It is a hybrid entity that combines the best features of an LLC and a corporation.I know a thing or two about the challenges of starting a new business. As the owner of several businesses in the entertainment industry in Los Angeles, I know from experience that you will have a quadrillion questions.
You should take notes like this guy.
And one of the first questions you’ll probably ask yourself is: What is an LLC and how does it differ from a corporation? So, of course, your next question will be: So… which one should I install?
Most people on the go have to choose between a corporation (also known as an Inc.) and a limited liability company (also known as an LLC). This can be a tough decision, especially since it’s hard to understand the differences (not to mention that it might be more beneficial to you)!
DISCLAIMER: Let me stop there and say that I am not a CPA or an attorney. I am an entrepreneur who has founded several companies and other organizations working in the real estate industry. So what I write here is what I have learned myself over the years (largely from my CPA and attorney). Consult your own accountant or attorney before making a final decision on what to do for your business!
Before going into some of the key differentiators, let me answer the question: …..
An LLC, or limited liability company, is a legal entity you create to protect your personal assets from liability. This will also determine how your business income will be treated during the tax period.
However, it is not the only trade organisation to do so. It’s one of the few.
The other most common option is the corporation (also known as a Corp. or Inc.). Corporations are another business entity that also provides protection from liability. But they are structured a little differently than LLCs.
They are completely separate from their owners, who own the property through shares (or interests) in the company.
These two versions of corporate structures have similarities and, of course, differences. Choosing between the two options depends on the nature and needs of your business, as well as your own liability and tax planning goals.
An LLC is usually owned by one person or a small group of co-founders. But technically an LLC doesn’t have owners, it has participants.
The rules for the management of the LLC are set out in the Operating Agreement. It should further be noted that all participants may manage the LLC (called the managing participant) or a particular participant may manage the LLC (called the managing participant).
Meanwhile, Inc. is owned by the people who own the shares, and management is accountable to those shareholders. Since a corporation is something very different from its shareholders, a shareholder can sell his or her shares to someone else and the corporation can continue to operate freely.
For this reason, most private investors prefer a corporation over an LLC as their legal form. And eventually, when the company grows and goes public, this step will be much easier.
One of the reasons it’s worth making your business an LLC is that, as the name limited liability company implies, it legally creates a barrier between the business operations and the personal assets of its members. The debts he has accumulated will not pass to you if he, for example. B. has legal problems. (Unless the debt is personally guaranteed).
Nonetheless, the Inc. offers virtually the same liability protection as an LLC, particularly for Inc. owned by singles or spouses. By the way, this information comes from my lawyer, so you can be sure of its accuracy.
Ultimately, both protect you in the same way if the company is sued. However, if you are personally sued, the LLC may be better off. Why? If you are sued personally (for example, as a result of a car accident) and you lose, the lawsuit may take possession of your shares in the company, giving you control of all assets. Wow.
If you now own an LLC, the winning bidder cannot take possession of your interest in the LLC. You can get a court order to seize your income from the LLC, but you can still control what income you receive. Bonus for the LLC!
One of the most discussed issues when choosing between a limited company and a limited liability company is the paperwork involved.
In general, there really is less paperwork in an LLC, mainly because there is no need to hold annual board meetings or take minutes of the meetings. Nor is it obliged to issue share certificates to its members.
It is also true that a sole proprietorship LLC does not have to accrue wages or even file a tax return (since all profits are reported on the sole proprietor’s Form C). This would make sense, but as you will see below, it comes with a relatively high financial cost.
So if you convert your LLC to an S-Corp to save on taxes, you essentially have to create a payroll and file a tax return for that organization. But again, there is still the LLC/corporation, which generally has less paperwork.
Tax savings used to be the main factor in choosing between a corporation and an LLC. Ironically, both companies can be classified as C-Corps and S-Corps for tax purposes, making them virtually identical. But let’s take a closer look….
A little corporate tax humor for you!
Just as the tax applies to independent contractors on the basis that it is personal income, the same status applies if you are the sole owner receiving income from the LLC. Simply put, a single-member LLC is not required to file a tax return. Instead, your net income will be reported on your personal return under Schedule C.
An LLC with multiple owners is taxed as a corporation, which means the organization must file a tax return. However, net income is still only reported on Form K1 directly with the member’s personal tax return.
In both cases, the organization itself pays no taxes because the LLC’s profits are transferred directly to the participants. So it’s a case of start to finish.
Moreover, in both cases (especially in the case of a limited liability company), the profits distributed through the company are subject to self-employment tax (an additional 15%) in the personal income tax return. The same is true for 1099 receptions. It is very important to notice this! (More information on this topic follows below).
OPINION: The K1 is a tax document received by the business owner at the end of the year that reflects the income of the business. It is similar to the W2 received by a salaried employee or the 1099 received by a self-employed person.
Corporations, on the other hand, are taxed as if they were a separate legal entity. Sales proceeds are treated as personal income.
A C corporation makes money, has expenses it can deduct, and pays federal (and often state) taxes on the net income. It doesn’t go to the shareholders. However, you can convert the company into a full-fledged corporation by choosing S corp (see below).
Income tax and dividends are also payable. If you are a shareholder, dividends in particular are double taxed because they are not deductible (which is why people often avoid C corporations).
This rule encourages owners to reinvest money back into the business rather than withdraw it from the business as it grows (to avoid double taxation). This also means that company C is not obliged to pass on the profits if it does not wish to do so. Instead, they can just keep them and reinvest in the company.
Don’t think you’re out of the tax forest yet! Your state will probably charge you some of the taxes as well.
There are actually two types of state taxes that you may encounter. First, there is the net income tax, commonly known as the income tax. But again, only the C corporation (or the non-passive corporation) pays income tax.
In addition, some states also apply a privilege tax (often called a franchise tax or minimum business tax).
The privilege tax is exactly that. Tax for the privilege of doing business in this state. This tax is often based on a company’s gross income, with a set minimum amount.
OPINION: The income tax rate may be the same for LLCs and Inc. but it often varies ….. Yes! I have noticed that liens are often higher for LLCs than for INKs. But that depends on the state.
To make things even more confusing, most states also require you to submit an annual report detailing any changes (or lack thereof) in your organization. Unfortunately, such a report is usually not free.
In some states, the annual return tax is one with the lien tax. In other cases, there may be no privilege tax, but there may be an annual charge. To make matters worse, in some cases only the privilege tax is collected and there is no annual fee! Yeah, yay-yay!
Suffice it to say that you need to do some research on the subject. You can read my article on annual filing requirements for S corporations in all 50 states, where I described much of this!
At some point it became possible to assign the name S Corporation to your company (which by default is a C Corporation). As a result, the group essentially becomes a single company. But the S-Corp exists only as a tax option, not as a particular type of organization.
This means that all profits are no longer taxed at the company level, but are passed on to the shareholders. BUT, since in a corporation the owners (assets) are also considered employees, you must perform some payroll operations for the owners.
The usual practice (for sole traders) is to give yourself a percentage of the profit as W2 salary and the rest as profit. Of course, you should ask your accountant about this percentage. But it’s also an important tax distinction (more on that later).
This practice can also be useful to avoid taxing your entire business profit if you only receive a small portion as income.
Interestingly, LLCs can also apply to the IRS to be designated as an S-Corp. In the case of an LLC classified as S-Corp, the owner is considered an employee (as in Inc./S-Corp).
So instead of simply treating the organization’s income and expenses as personal income on their tax return (i.e., their Schedule C), they must include a portion of the gain as W2 wages.
In fact, both LLCs and partnerships can qualify as S corporations if they choose to, although there are some limitations. For example, an S-Corp cannot have more than 75 shareholders and each shareholder must be a US resident.
So this is one of the most important things to know about bolognese! Some time ago, I wrote that….
1) The LLC transfers all profits to the participants and is then subject to the 15% self-employment tax.
The reason is that the federal and state governments want money for Social Security, Medicare and unemployment insurance. But since you don’t receive a W2 paycheck, it won’t be deducted from your paycheck. Instead, they impose a tax on self-employment.
2) I also mentioned that the S corporation considers the owners to be employees, which means you have to pay yourself a salary in the form of a W2….. form and therefore pay social security contributions.
HERE’S THE TRICK. With an S-Corp, you only have to pay yourself a reasonable salary in the form of a W2. This is generally considered to be around 40-60% of your profit, but it could be more, and it certainly depends on your CPA’s advice.
The rest of the profits come from the aforementioned K1. BUT, for some reason, this K1 income is NOT subject to self-employment tax. How to save money on your taxes!
Here’s a tax calculator I created that illustrates how tax savings can work. But again, you should consult with your financial controller to see if you and your business can take advantage of these potential tax savings.
This calculator shows you the difference in taxes you pay if you earn income as a W2 employee, 1099 contractor, or S-Corp. Again, this is only an estimate. Talk to your financial controller about your specific situation!
If you want to get your hands on this calculator, you can do so by taking my free course Founding Your Business.
- An LLC may have INC/C, INC/S, LLC/S, LLC and natural persons as members.
- S-Corps can only have an individual (or living trust) as a shareholder.
- The S-corporation can be converted into a C-corporation, but you have to wait 10 years to convert it into another company.
- According to my accountant: With the exception of medical deductions, S corporations are generally more tax efficient.
- According to my accountant: Statistically, S corporations are audited less frequently than all other organizations.
- If you have losses in a C corporation, nobody wins because they don’t transfer. In contrast, in the case of S-Corps and direct LLCs, the losses are passed on to the owners.
- Customers are required to send a Form 1099 to a single-unit LLC and an affiliated LLC. However, you are not required to send a 1099 to an INC/C corporation, INC/S corporation, or LLC/S corporation. You are subject to the honor system of these entities with respect to reporting your income to the IRS.
For a small business, conversion to an LLC (with the possibility of an S-Corp) may be the best option, especially if the business is small and wants to minimize the complexity of its tax affairs while protecting the owners from undesirable legal consequences.
But still: Before you go down this road, you should look at the taxes levied on the LLC at the state level. Personally, I think an INC/S corporation is the best option for sole proprietors or spouses. That’s what I do, but I can’t tell you what to do. It’s up to you.
Growing companies with multiple owners who are considering forming a corporation, but do not want to commit to a full C corporation, may want to consider the benefits of S corporation status. You can even revert to a C corporation if necessary.
This article was originally published on Your Money Geek.
Frequently Asked Questions
What is better a corporation or LLC?
Why choose an LLC over a corporation?
An LLC is a type of business entity that offers the same limited liability protection as a corporation, but with fewer formalities.
What is the downside to an LLC?
The downside to an LLC is that it is not a tax-advantaged entity.
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