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Owners of new businesses often choose to form a Limited Liability Company (LLC) for two primary reasons. The first of these reasons is to limit their personal liability by setting up the business as a separate legal entity. The other reason is for taxes and to avoid the double taxation that is common with the corporation.
Owners who choose not to form an LLC and operate as a sole proprietorship or as an unincorporated partnership accept the risk of being personally responsible for business debts and any business-related lawsuits. This means that a business creditor, as well as someone who has won a lawsuit against a business, may come after the owner personally for payment. This means that a business owner’s home, car or personal savings could at risk. Having an LLC does not completely keep an individual from paying back all business loans as many loans will need a personal guarantee, but will typically shield their personal assets from lawsuits.
Incorporating can also limit personal liability but the LLC avoids double taxation.
What is Double Taxation?
Double taxation occurs when a C corporation’s profits are taxed and then the remaining dividends are taxed as well.
When a C corporation earns a profit, those business profits are taxed at the business’s corporate tax rate.
Any remaining profits from the corporation are distributed as dividends to the shareholders. Once the owner receives these dividends, the dividends are taxed personally as 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”. In some situations, this can reduce an individual’s tax rate.
How does an LLC Avoid Double Taxation?
An owner, or “member”, of an LLC, can completely avoid double taxation by electing to organize as a pass-through entity for tax purposes. An important feature that is unique to the Limited Liability Company that is tax flexibility. This tax flexibility allows the LLC to be taxed as a disregarded entity as either a sole proprietorship, partnership or S Corp.
A disregarded entity is also called a pass-through entity. The owners of these entities report business income on their personal tax returns. By doing so, the owner will only pay for taxes once, in the form of a personal income tax. In this instance, the entity doesn’t pay taxes on profit. Instead the members pay the taxes of the business on their personal tax returns.
The IRS and state laws have made designating pass-through taxation easy by providing a selection box when filing the Articles of Organization form.
An LLC can also choose to be taxed as a C corporation. The C corporation and S corporation elections are much more complicated than a sole proprietorship or partnership. Not only do corporations have administrative requirements like a board of directors meeting, shareholders meeting and taking minutes at the meetings, owners working in a corporation must also take a salary just like an employee. These salaries require the payment of withholding tax. Accounting is also more complex because the C corporation tax status means profits are taxed and the dividends to shareholders are also taxed. The S corporation does not have double taxation as all taxes on profits are passed through to the owners. All of this requires additional accounting work. An additional benefit of electing S corp status is that as long as the members take a “reasonable salary”. A reasonable salary as defined by the IRS varies by the industry, difficulty of the tasks being performed and number of hours worked. After salaries are taken, any profits left over can be distributed as a dividend payment, which isn’t subject to employment taxes.
An interesting benefit of the LLC is the ability to change its tax status at any time. There are some restrictions with the primary one being a 60-month limitation rule from the IRS between changes. This benefit can be important the tax status in the early stages of a business may not be optimal later on as the business grows, resulting in tax savings without having to form a new entity.
The LLC is an excellent business structure as it provides the pros of the corporation by having the legal protection without the issue of double taxation in addition to the flexibility for taxes and ease of operation, making the LLC a popular choice for a business entity.