Choosing the correct entity structure is a concept that many LLC’s and small business owners often overlook in their attempt to reduce their tax bill, as opposed to more commonly known strategies like deducting business expenses and depreciating assets, but there are a few situations where filing as a different entity can reduce your tax liability significantly. A popular trend for small businesses is to incorporate as a Limited Liability Corporation within their state of operation. A LLC shelters your personal assets from possible litigation against your company in most cases, but from a tax perspective, a limited liability corporation does very little, in fact, the IRS does not recognize an LLC as an entity for tax purposes. Businesses that incorporate as an LLC will usually file their taxes as one of the following—a Partnership, S Corp, or Sole Proprietor. (Companies can also choose to file as a C corporation as well, but you will be subjected taxation at the corporate and personal levels.) There are some advantages and disadvantages associated with each of these different filing entities, and being informed about each of them can be a major asset for your business going forward. Sole Proprietors are unincorporated businesses or LLC’s with one owner, they usually file their business taxes using a schedule C, or schedule E on their 1040. Filing your business taxes using a schedule C is by far the easiest and cheapest way, mainly because of the simplicity of the forms in comparison to corporate returns, but if you have more than one owner, filing this way is not possible, you are considered a partnership. Profits from a sole proprietor business are added in to your adjusted gross income and are also subject to the self employment tax of 15.3%. The IRS deems your business a general partnership if two or more persons join to carry on a trade or business, and each share in the profit and losses. (Incorporating as an LLC will not affect your partnership status; the LLC will make it less complicated to declare a different entity though, like an S Corp.) If this is the case for your business, you will need to file a federal 1065 form at tax time and a corresponding state partnership form. A partnership itself does not actually owe income tax, but the profits from it flow through to each partner’s personal income tax return via a K-1 form. Income from a partnership is also subject to self employment tax of 15.3%, that fact in many cases is what makes an S Corp a better option for some small businesses. As mentioned above, changing your entity structure from a partnership to an S Corp can actually lower your tax bill each year. This is possible because S corp profits are broken down in to two different buckets of income, owner’s salary and distributive share; only an owner’s salary is subject to the self employment tax. A word of caution though, you cannot set your salary at a ridiculously low level to avoid this tax, owner’s salary needs to conform to the fair market wage for that job in your specific area. Let say for example that you set your salary around 50,000 dollars for the year, any profit above and beyond that total that your company makes will be considered a distributive share, and consequently not subject to the self employment tax. If your entity structure was still a partnership, or schedule C sole proprietor, all of the profits would be subject to a 15.3% tax. An S corp files a 1120-S form at tax time along with their corresponding state’s subchapter S corporation tax form. Profits from the business will flow through to your personal 1040, just as a partnership would, and will be taxed at your personal marginal tax rate. Small business owners will need to first form a corporation, like an LLC, and then file form 2553 with the IRS to declare subchapter S. You will also need to call your state’s government to find out if they will require you to pay any additional fees. |
| How your LLC’s Tax Entity can Affect Your Bottom Line |