When deciding on a small business tax strategy, one option is establishing a limited liability company (LLC). A LLC is a type of small business where the number of owners is unlimited, and the structure is similar to a partnership. The benefits and restrictions associated with this type of business structure combines the limited liability of corporate shareholders with looser legal restrictions and the tax benefits of a partnership.
What Is Limited Liability?
A limited liability company protects owners from liabilities incurred by the company: lawsuits, debt liabilities, etc. However, a member may be held accountable for any contracts, debts and liabilities they personally incur in his name and not the through the LLC.
If the LLC engages in fraud, fails to comply with basic business capitalization principles, or does not fulfill legal corporate standard policies, the members of the LLC may be liable under the piercing-the-corporate-veil theory.
Limited Liability Company Taxing
Under a LLC, you are subject to taxes on the profits you earn as a member. A LLC is not taxed as a business entity, per se. The LLC members report profits, losses, and expenses passed through the business on their personal tax returns.
Here is a summation of the money flow through a LLC to its owners:
- LLC members receive a yearly salary.
- A tax form is issued to the individual LLC owners, showing their share of the equity in the company and current profit or loss.
- This form is used by the LLC member to file a personal tax return, based upon their yearly salary less the business expenses (business, property, and capital expenses).
LLC as a Small Business Tax Strategy
Creating an LLC as a small business tax strategy is a prime way to avoid the double taxation that is so often associated with other forms of business structures. Typically, if you worked for an employer or a corporation, you would pay personal taxes on your salary. If you owned stock in the corporation, you may also be required to pay capital gains taxes on the stock owned, based on the increased value of the shares. Whether the company actually makes money or not has no direct effect on how much tax you pay.
With a LLC, you can still earn a salary, but since that salary is a company expense, it is offset on your personal tax return, possibly creating a zero tax liability on your salary.
Here is simplified example of what happens:
- Tom earns an annual salary of $30,000. His partner also earns a salary of $30,000. They are equal partners in the business.
- The LLC records would indicate $60,000 in salary expense.
- Tom reports $30,000 in earned income on his personal tax return. He also records his share of the company's salary expense, which as a 50 percent owner is $30,000.
In effect, he has reported zero net income. Of course, if the company earns money from the products or services offered, there is a tax consequence on the income earned above the expense of selling the product or service. However, he has still reduced his tax liability by the amount of taxes that may have been due on his salary.
Who Should Establish a LLC?
Every small business tax strategy is different. You should decide if a LLC is best for your business. Typically, a LLC is best suited to companies with a small number of owners. For tax purposes, it might be more advantageous to establish yourself as an S-corporation if you are a larger business with many owners/members/employees.
Small Business Tax Strategy Conclusion
If you are beginning a small business, an LLC might be the small business tax strategy you seek. Like a partnership, a LLC distributes its losses, income, and expenses through to the members. Members also receive a salary amount, which also written off as expenses. This means taxes are paid only once, instead of double taxing as in a corporation set-up.
To establish your small business as a limited liability corporation, consult with your Secretary of State regarding the proper procedure, fees, and filing requirements. As always, it is a wise idea to discuss tax strategies with a trained professional prior to establishing a new business.
Written by Christina Freeman