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Entity Selection and Demystifying the Limited Liability Company
Entity Selection is a big topic for most individuals starting a business. The Sole Proprietor is the simplest entity type because there are no extra tax returns due and no annual Franchise tax owed ($800 per year in California regardless of your income or loss). However, Sole Proprietors and Partners in partnerships are subject to personal liability. This means that if there is an incident in a Sole Proprietorship or Partnership that results in a loss or a lawsuit, the personal assets of the Partners or Sole Proprietor are at risk. Corporations and Limited Liability Companies (LLCs), on the other hand, offer personal liability protection, which helps ensure that a loss or incident that occurs doesn’t result in exposure of personal assets. For this reason, many small businesses are choosing to operate as Corporations or Limited Liability Companies. Keep in mind that the tax consequences for LLCs can differ dramatically depending on the number of members and whether or not certain “elections” are made. For example:
• An LLC with only one member is considered a “disregarded entity” by the IRS. It is not taxed as an entity and does have to file a separate tax return for the business, but still has to pay annual Franchise tax. The owner/member reports the profit or loss on Schedule C of the 1040 (personal tax return), just like a Sole Proprietor does.
• An LLC with 2 or more members that has not made any special elections (noted below) is not taxed at the entity level but still needs to file a separate tax return (Form 1065) and pay annual Franchise tax. The profit or loss from the business is reported on Schedule K-1, which is included in the member’s personal tax return.
• An LLC can make an “S-Corp Election” and it will also not taxed at the entity level. It also needs to file a separate tax return (Form 1120S in the case) and pay annual Franchise tax. The profit or loss form the business is reported on a Schedule K-1, just like the default LLC, which is included in the member’s personal tax return.
• An LLC can make a “C-Corp Election” which will make it operate like a regular Corporation. It needs to file a separate tax return (1120 in this case) and WILL pay tax on the profit generated by the business. Nothing flows through to members or shareholders as in the case of the default LLC or S-Corporation. This can result in “double taxation” because the shareholders pay both corporate tax and personal income tax on wages paid through the corporation.
One of the biggest areas of confusion about multi-member LLC's is the issue of Self-Employment taxes. The difference between being General Partner v.s. a Limited Partner is significant! If you are considered a Limited Partner, there is no self-employment tax on your share of LLC income (except for guaranteed payments). However, if you are a General Partner, you must pay Self-Employment taxes on your portion of LLC income. Self-Employment tax is significant, totaling 15.3% of net income from the business.
Most small business owners operating as LLCs are probably considered General Partners so cannot avoid the Self-Employment tax. You are considered a General Partner if you:
• Participate in the trade or business for more than 500 hours during the taxable year.
• Have personally guaranteed debts of the entity.
• Have authority to contract on behalf of the entity.
If you are simply an investor in an LLC and not actively participating in the operations of the entity, you are probably considered a Limited Partner and are safe from Self Employment Tax.
One way to avoid Self Employment Tax for General Partners of multi member LLCs is to make the “S-Corporation Election”. This is done by filing Form 8832 within 75 days of the year in which you want the election to be effective (normally March 15). Here’s how it works: Even though both LLC and S-Corporation’s income or loss flow through to members or shareholders personal tax returns via the K-1, the magic difference is where it lands in the 1040. In a regular LLC, the income flows through to Box 14 on the K-1 and Self Employment tax is calculated on the entire amount. In an S-Corporation, the income flows to Schedule E, which is used for passive income like that from rentals, royalties or investments and is NOT subject to Self-Employment tax. This is a huge deal!!! The only catch is that the IRS frowns on S-Corporations who do not pay shareholder owners enough via payroll, so it’s a good idea to pay a decent portion of the earnings to shareholder owners in the form of wages to avoid audit. Still it can be a substantial savings considering only the portion paid though wages is subject to withholding and employer taxes (which happen to total 15.3%, same as the Self-Employment tax).
Here’s one thing to keep in mind before getting overly excited about avoiding Self-Employment tax through the S-Corporation or S-Corp election: You can only contribute to a Retirement plan based on EARNED INCOME. Income from an S-Corporation is NOT considered “Earned”, it is considered “Passive”. So if part of your goal is to put away maximum dollars in a retirement account, the S-Corporation won’t help you unless you pay yourself mostly through W-2 wages anyway – which means you are still paying the 15.3% tax through Payroll!
A good strategy for a start-ups or struggling businesses might be to do the S-Corporation election and pay a smaller percentage of earnings via payroll in the early years. This will help you pay less in taxes initially so your cash flow will be better and you can use the extra cash to grow the business. Once the business is more solid you can change the percentage you pay yourself through wages so that you can maximize retirement plan contributions.
Please feel free to consult me about entity selection options. I can help you form your entity, make appropriate elections and consult with you on ways to maintain the protections offered by an LLC or Corporation.