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Owners of new businesses choose to form LLCs for two primary reasons. The first of these is to turn their business into its own entity that exists as a separate thing from their person. By doing so, they limit their personal liability for their business debt.
Conversely, owners who choose not to form an LLC and operate as a sole proprietorship or as an unincorporated partnership accept the risk of being held personally responsible for all of their business debts – including lawsuits. This means that a business creditor, as well as someone who has won a lawsuit against your business, may come after you personally for payment. This means that your home, car or personal savings could be taken away.
A traditional form of incorporation can accomplish the same goal of limiting personal liability, however forming an LLC can offer even better protection by helping you to avoid double taxation.
When a corporation earns a profit, it is taxed at a special corporate rate. The corporate rate is similar, but not identical, to personal income tax rates.
Before the owner of a corporation can spend the corporation’s leftover profits, they must receive them into their personal accounts as dividends. Once the owner receives these profits, the money will be taxed again in the form of a personal income tax. In this way, taxes are collected from one pool of money two times (first as a corporate tax, and then as a personal income tax on dividends) hence the term “double taxation”.
An owner, or “member”, of a business that is formed as an LLC can completely avoid double taxation by choosing to organize as a pass-through entity.
By doing so, the owner will only pay for taxes once, in the form of a personal income tax. The IRS and state laws have made designating pass-through taxation relatively easy by providing a selection box on your state’s Articles of Organization form.