Making your small business an LLC; when is it the right time?

Small BusinessYou have, own, or are a small business. Everyone tells you to become an LLC. So should you? We cannot go into all the complexities here without putting everyone to sleep, but we will try our best to give an overview that will make sense to an ordinary, non-accountant, small business person.

We’ll start at the beginning. The minute you begin to make money of any kind outside of a wage job, you are a small business. Teach music lessons? Small business. Tutor? Small business. Mow lawns on the side? Small business. And you must claim this income on your tax return, no matter how small. When you start/become a small business, by default you are a sole proprietorship for tax purposes. A sole proprietorship is the most simple form of a business:

  • You don’t need to file any paperwork with any government entity to start one, you don’t need to file any special reports, get special numbers, pay special fees, or put accounts such as cell phone accounts under the business name.  You don’t even have to give the business an official name!
  • As the word “sole” implies you are the only owner of the business.
  • You also don’t need to file a separate tax return for the business.When you are a sole proprietor you will merely report all your income and associated business expenses (remember to keep track of them all! It’s anything that assists you in making money for that business!) on your personal tax return on what’s called the Schedule C, Profit or Loss from Business. You then pay the 15% self employment tax on the profit (which comes in lieu of payroll taxes that are usually taken from employees’ paycheck wages).

A sole proprietorship is the most hassle-free way to operate. It may be the best option for small operations where there isn’t much intention of growing the business, making lots of money, or if the business is not risky. However nice the hassle free approach might be, it isn’t right for every business. Converting your business to an LLC may be the way to go.

The first and foremost benefit of an limited liability corporation, or LLC, is the liability protection. It makes a business legally separate from the owner. So if someone sues the company, the owner’s personal savings and house are protected; the suit cannot take anything beyond the LLC’s assets. It also means most or all company debts do not have to be paid with the owner’s monies and assets; debt collectors would only be able to use the LLC’s assets to pay debts.

From a strictly tax prospective (which is our specialty), one consideration to think of when forming an LLC is whether there is one owner or more. If there is only one owner, an LLC is given the name “disregarded entity” and is by default taxed as a sole proprietorship. You can, however,elect to be taxed as a corporation or S corporation.

If there is more than one owner in an LLC, there are some tax advantages to consider.

  • An LLC can choose to be taxed as and file its tax return as a C corporation, S corporation, or partnership. This can allow the company to be taxed in the way that best suits the company.
  • The company can save money in the form of saved payroll taxes as the owners can take both salary and distributions–owner withdrawals from the company’s earnings which are not subject to payroll taxes–instead of strictly salary which is always subject to payroll taxes.
  • If the LLC chooses to be taxed as a partnership or a S corporation it is taxed only once instead of twice like a C corporation. Partnerships and S corporations are known as pass through entities meaning the company itself does not pay tax on the profits, but instead profits are passed through to the owners’ personal tax returns where they are then taxed.
  • If the LLC chooses to be taxed as a partnership or S corporation it can divide the profits or losses between the owners in a beneficial way. For example, if one owner is in a lower tax bracket the LLC can pass down a larger share of the profits to that owner, meaning overall lower taxes paid.

To read more about the advantages and disadvantages of an LLC, the wikipedia page has a good list.

This article skims the surface of a complex issue and legal and/or financial professionals should be consulted before final decisions are made.