Most times we are asked if forming an LLC is a good idea the question is laced with tax implications. More accurately, the asker is wondering, “Would forming an LLC help me pay less in tax?” Of course the question is more complicated than a Google search would have you believe. Deciding to form an LLC is both a legal question and a taxation question. Both must be considered simultaneously. When advantages arise in both areas, forming an LLC is a no-brainer. However, it’s common that only one area would benefit while the other would have little to no impact. Consider your business goals and needs and discuss the benefits with an attorney and accountant before making a final decision.
Legal Considerations
The legal benefits of forming an LLC are not a forgone conclusion. Both pros and cons must be considered. The main legal pros of forming an LLC (Limited Liability Company) are:
- Personal liability protection: One of the main benefits of an LLC is the opportunity for personal liability protection to its owners (called "members"). This means that if the LLC is sued, the members' personal assets, such as their homes and savings, are may not be at risk.
- Flexibility: LLCs have flexible management structures and can be managed by the members themselves or by a board of managers. This allows for a customized approach to managing the business.
The main legal cons of forming an LLC are:
- Case law for LLCS: LLC’s are defined by state law. Each of the 50 state laws may vary and cause legal complication when operating in multiple states.
- Ongoing compliance requirements: LLCs have ongoing compliance requirements, such as holding annual meetings and keeping minutes of those meetings. Failure to comply with these requirements could result in the loss of your LLC's legal status and the personal liability protection it offers.
- Limited lifespan: LLCs may have a limited lifespan and could dissolve when a member leaves or dies unless the operating agreement provides otherwise. This can be a disadvantage compared to other business structures, such as corporations, which have an indefinite lifespan. 4. Limited ownership: LLCs may be limited to 100 owners, which can be a disadvantage if you are planning to seek venture capital funding or have a large number of shareholders.
Tax Considerations
Forming an LLC allows you to choose how you would like your business to be taxed. LLC’s strength is the ability to select the tax status suiting it best. By default, an LLC with one member is taxed as a sole proprietorship, and an LLC with multiple members is taxed as a partnership. However, you can elect to have your LLC taxed as a corporation by formally requesting a change of taxation with the IRS.
If you choose to be taxed as a corporation, your LLC will have the option of being taxed as a traditional C corporation or as a small business corporation (also known as an S corporation). A traditional C corporation is taxed on its profits at the corporate level, and then the shareholders are taxed again on any dividends they receive from the corporation. It's important to note that LLCs that are taxed as corporations may be subject to double taxation, as both the corporation and its shareholders are taxed on the company's profits. This can be a disadvantage compared to other business structures, such as sole proprietorships and partnerships, which are not subject to double taxation.
An S corporation, on the other hand, is not taxed at the corporate level. Instead, the profits and losses of the business are passed through to the shareholders and reported on their personal tax returns. S Corporation members who perform services for the company must be paid a “fair wage” throughout the year, pay payroll tax, have taxes withheld, and receive a W-2 like other employees.
Funding Considerations
It can be helpful to consider how your LLC will be funded when deciding how it will be taxed, as certain funding sources may be more tax-efficient than others.
For example, if you are planning to seek funding from investors in exchange for a percentage of equity in your LLC, you may not be taxed as a sole proprietorship. Additionally, you may want to consider electing to be taxed as a corporation (either a traditional C corporation or an S corporation). This is because investors may be more likely to invest in a corporation, as it offers the potential for a financial return in the form of dividends or capital gains. S corporations are limited to 100 investors.
On the other hand, if you are planning to fund your LLC with business loans or with personal savings, partnership or sole proprietorship may suit.
Consult your attorney and tax advisor
It's important to keep in mind that each business structure has its own unique legal, tax, and funding implications. The best choice for your LLC will depend on your specific business goals and needs. It may be helpful to consult with a lawyer and accountant to understand the tax implications of each option and to determine if an LLC is right for your business.
Be sure to inquire about the costs for registering the LLC, additional operating costs, and what is involved in shutting down the LLC if necessary.
