A limited liability company is a business structure that combines the features of a corporation with those of a sole proprietorship or a partnership. This is to say it’s easy to set up and the owners are not personally liable if the business is experiencing financial problems.
It's the best business structure for small business owners.
And it gets better. You don’t have to file taxes on a business level. You get to file taxes just as if you were running or starting a sole proprietorship or a partnership.
Wondering if an LLC is the right business structure for you? In this post, we will explore all the advantages of setting up an LLC as well as the disadvantages.
We will also look at how to set up an LLC and conclude by exploring LLC tax benefits you can exploit.
Every year thousands of companies end up overpaying their taxes but, thankfully, that doesn’t have to be you. This is because we will also explore how you can reduce your tax debt by writing off business expenses.
It doesn’t matter if you are a hobbyist looking to legitimize your business or an informal business owner looking to make your business formal, this article will tell you everything you need to know about LLCs and how they are taxed.
Still, if you need the best insights on the topic we recommend you seek the services of an attorney or law firm.
Note: If you are a self-employed worker who would like to manage all of your invoices, contracts, proposals and taxes in one place, then try Bonsai. Our app can help you streamline these tasks with our templates and expense tracker for taxes. Claim your 14-day free trial today.
Let's quickly breakdown the benefits of limited liability companies.
A Limited Liability Company protects the personal assets of its owners/members in case there are problems with the business. Creditors cannot touch personal bank accounts, cars, houses, or any other investment owned by LLC members even if the company goes bankrupt. This is why many sole proprietors change to LLC as their business grows.
Still, you have to be careful not to mix business transactions with personal transactions as that could lead to a situation called “piercing the corporate veil”. This is where a court decides to withdraw personal liability protection and hold LLC owners personally liable for the company’s actions or debt
If one of the partners has personal debt, the creditors can acquire a charging order from the court that allows them to take the partner's stake in the company. Registering your business as an LLC ensures the creditors can’t touch the earnings or ownership stakes of other members in the LLC.
Also, they can’t take over the administrative rights of the defaulting partner meaning they will have no say on how the business is run.
As an LLC owner, you only file individual taxes. The IRS does not require that you file separate income taxes for your business as is the case with some corporations.
Instead, the company’s net profit is considered as part of your personal income and subjected only to personal income tax rates. We will discuss this in more detail later when we discuss how Limited Liability Companies are taxed and the steps you can take to reduce your tax burden.
LLCs are more flexible than corporations when it comes to management. For starters, they have no ownership restrictions. This is different from corporations that can’t have more than 100 shareholders and are not allowed to have foreigners as shareholders.
Also unlike corporations, LLCs don’t require to hold annual shareholder meetings or make annual reports. There is also no established management hierarchy. You don’t need to have a board of directors that's responsible for overseeing company business. You decide amongst yourselves the responsibility of each member.
The process to form an LLC is straightforward and in most cases won’t require that you seek special expertise. No strings of paperwork to fill and the setup cost is also relatively low. It ranges from $40 to $500 depending on the state.
Discover the best states to start a limited liability company.
You will command more respect as an LLC than as a sole proprietorship or a partnership. Consequently, you will attract better clients that guarantee more profits for your business.
As we mentioned earlier, there are some instances that a judge can rule that your LLC structure does not protect your personal assets. Like if you failed to separate your business expenses from personal expenses. Or it was determined you were running the business fraudulently.
Luckily some of these issues can be avoided by using bookkeeping solutions that track your business transactions.
As an owner of an LLC, the IRS requires that you pay self-employment taxes based on your company’s net income. In contrast, if you are being taxed as a corporation you would only need to pay self-employment tax based on the salary you get from the corporation.
In most states, if a member of the LLC leaves the company, goes bankrupt, or dies, the company ceases to exist. The remaining owners are then left with the responsibility of facilitating the termination process.
You will have to file new documents to continue with business operations.
Adding new members to a corporation is easy because it’s only a matter of buying and selling shares. In contrast, a new member can only be added to an LLC through the mutual consent of all its members.
And even if all the members agree on it, there is the added complexity of determining how the new member fits into the business. What percentage of the business are they entitled to, do they get the same privileges as older members who founded the company?
These are the main steps involved in setting up a limited liability company.
By default, an LLC is a pass-through entity meaning that it’s not taxed at the business level. All profits from the company are declared on the members’ personal income and subjected to individual income tax rates
Payments made to members are known as distribution and will be subjected to self-employment tax. However, since you already paid income tax on the LLC’s net income you won’t have to pay income tax on the distribution.
That’s the basic taxation rule regardless of whether you are running a single-member LLC or a multi-member LLC.
However, there are instances when single-member LLCs and multi-member LLCs can choose to be taxed as corporations. In such cases, they can either elect to be taxed as an S Corporation or as a C corporation.
If your business is making a lot of profit such that it can afford to pay its members a good salary and regular yearly distributions of about $10,000 or more, that would be a good reason to choose to be taxed as an S Corp.
This is because, in an S Corporation, you only need to pay FICA (medicare and social security tax) on salary and not on distributions which saves you about 16% on taxes.
Also, if you are unable to spend most of your business profits on expenses that grow your business, that would be another good reason to choose to be taxed as an S Corp.
This is because a corporation is taxed at about 15% for all profits that carry over to the next tax year. On the other hand, single-member and multi-member LLCs have to pay FICA taxes as well as federal income taxes which will be significantly higher than the 15% corporate tax.
A C Corporation works the same as an S-corporation only that you will also be required to pay taxes on a business level. C corporations first pay taxes on their net income and then after members have received their share of the profits, the members are required to pay taxes on that amount.
This is known as double taxation.
However, if you are planning to bring investors on board, electing the C Corp tax status will help lure them to your business because they only pay taxes for dividends they have received.
In other tax classifications, they have to pay taxes on net profit even if the profits were not disbursed.
The best thing about making your business formal is the IRS allows you to write off business expenses from your gross income. This consequently results in a reduced taxable income and hence less tax paid.
However, a lot of business owners fail to take advantage of these deductions because of two main reasons. Either they don’t know the expenses that can be deducted or, they lack proper documentation to prove that certain transactions are business expenses.
So, in the final part of this post, we are going to explore some business expenses that can be deducted from your gross business income and how to properly track them so that they are accepted by the IRS.
Every expert will tell you that the key to a smooth tax filing season is proper bookkeeping. You need to have proper records of all business transactions including invoices paid and receipts for every expense incurred.
As you might imagine, keeping up with these records is not easy. Especially if you are doing it manually. Filing receipts is an option but there is always the danger that the receipts may get lost or get exposed to water and become ruined.
This is why a lot of businesses prefer to have dedicated software that tracks their business transactions. Consequently, when tax season rolls in you will have all the relevant financial information to effortlessly file your taxes.
This is where we come in.
Our software integrates with your business account and credit card then proceeds to import and categorize your transactions. You don’t have to guess what a particular expense was for.
It also allows you to scan receipts for proper tracking of transactions made in cash. The receipt scanner is equipped with optical character recognition technology that reads the content on the scanned receipt and inputs the data on your expense report.
Most importantly, Bonsai tax tracks expenses that are deductible in your LLC and automatically writes them off. The tool will then use all this information to estimate your company’s quarterly taxes.
This is a great feature that will help ensure that tax season never catches you financially unprepared. It also simplifies work for organizations that have an expected tax liability of more than $1000, since the IRS, requires that they make quarterly tax payments.
Bonsai also comes with other extra features such as an invoicing system that supports automatic payment requests, payment reminders, and the option to add penalties for late payments.
The system supports multiple payment options including credit card, ACH, and PayPal.
You can try our software for 14 days at no cost. Moreover, if after 30-days of using the software you don’t see any value that it’s adding to your business we will refund your money.
A verbal contract (formally called an oral contract) refers to an agreement between two parties that's made —you guessed it— verbally.
Formal contracts, like those between an employee and an employer, are typically written down. However, some professional transactions take place based on verbally agreed terms.
Freelancers are a good example of this. Often, freelancers will take on projects having agreed on the terms and payment via the phone, or an email. Unfortunately, sometimes clients don't pull through on their agreements, and hardworking freelancers can find themselves out of pocket and wondering whether a legal battle is worth all the hassle.
The main differences between written and oral contracts are that the former is signed and documented, whereas the latter is solely attributed to verbal communication.
Verbal contracts are a bit of a gray area for most people unfamiliar with contract law —which is most of us, right?— due to the fact that there's no physical evidence to support the claims made by the implemented parties.
For any contract (written or verbal) to be binding, there are four major elements which need to be in place. The crucial elements of a contract are as follows:
Therefore, an oral agreement has legal validity if all of these elements are present. However, verbal contracts can be difficult to enforce in a court of law. In the next section, we take a look at how oral agreements hold up in court.
Most business professionals are wary of entering into contracts orally because they can difficult to enforce in the face of the law.
If an oral contract is brought in front of a court of law, there is increased risk of one party (or both!) lying about the initial terms of the agreement. This is problematic for the court, as there's no unbiased way to conclude the case; often, this will result in the case being disregarded. Moreover, it can be difficult to outline contract defects if it's not in writing.
That being said, there are plenty of situations where enforceable contracts do not need to be written or spoken, they're simply implied. For instance, when you buy milk from a store, you give something in exchange for something else and enter into an implied contract, in this case - money is exchanged for goods.
There are some types of contracts which must be in writing.
The Statute of Frauds is a legal statute which states that certain kinds of contracts must be executed in writing and signed by the parties involved. The Statute of Frauds has been adopted in almost all U.S states, and requires a written contract for the following purposes:
Typically, a court of law won't enforce an oral agreement in any of these circumstances under the statute. Instead, a written document is required to make the contract enforceable.
Contract law is generally doesn't favor contracts agreed upon verbally. A verbal agreement is difficult to prove, and can be used by those intent on committing fraud. For that reason, it's always best to put any agreements in writing and ensure all parties have fully understood and consented to signing.
Verbal agreements can be proven with actions in the absence of physical documentation. Any oral promise to provide the sale of goods or perform a service that you agreed to counts as a valid contract. So, when facing a court of law, what evidence can you provide to enforce a verbal agreement?
Unfortunately, without solid proof, it may be difficult to convince a court of the legality of an oral contract. Without witnesses to testify to the oral agreement taking place or other forms of evidence, oral contracts won't stand up in court. Instead, it becomes a matter of "he-said-she-said" - which legal professionals definitely don't have time for!
If you were to enter into a verbal contract, it's recommended to follow up with an email or a letter confirming the offer, the terms of the agreement , and payment conditions. The more you can document the elements of a contract, the better your chances of legally enforcing a oral contract.
Another option is to make a recording of the conversation where the agreement is verbalized. This can be used to support your claims in the absence of a written agreement. However, it's always best to gain the permission of the other involved parties before hitting record.
Fundamentally, most verbal agreements are legally valid as long as they meet all the requirements for a contract. However, if you were to go to court over one party not fulfilling the terms of the contract, proving that the interaction took place can be extremely taxing.
So, ultimately, the question is: written or verbal agreements?
Any good lawyer, contract law firm, or legal professional would advise you to make sure you formalize any professional agreement with a written agreement. Written contracts provide a secure testament to the conditions that were agreed and signed by the two parties involved. If it comes to it, a physical contract is much easier to eviden in legal circumstances.
Freelancers, in particular, should be aware of the extra security that digital contracts may provide. Many people choose to stick to executing contracts verbally because they're not sure how to write a contract, or they think writing out the contract terms is too complicated or requires expensive legal advice. However, this is no longer the case.
Today, we have a world of resources available at our fingertips. The internet is a treasure trove of invaluable information, platforms, and software that simplifies our lives. Creating, signing, and sending contracts has never been easier. What's more, you don't have to rely on a hiring a lawyer to explain all that legal jargon anymore.
There are plenty of tools available online for freelancers to use for guidance when drafting digital contracts. Tools like Bonsai provide a range of customizable, vetted contract templates for all kinds of freelance professionals. No matter what industry you're operating in, Bonsai has a professional template to offer.
A written contract makes the agreement much easier to prove the terms of the agreement in case something were to go awry. The two parties involved can rest assured that they're legal rights are protected, and the terms of the contract are sufficiently documented. Plus, it provides both parties with peace of mind to focus on the tasks at hand.
Bonsai's product suite for freelancers allows users to make contracts from scratch, or using professional templates, and sign them using an online signature maker.
With Bonsai, you can streamline and automate all of the boring back-office tasks that come with being a freelancer. From creating proposals that clients can't say no to, to sealing the deal with a professional contract - Bonsai will revolutionize the way you do business as a freelancer.
Why not secure your business today and sign up for a free trial?