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 7-day free trial today.
Let's quickly breakdown the benefits of limited liability companies.
Personal liability protection
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
Protection against charging order
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.
Easier to manage
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.
Easy to set up
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.
Disadvantages of an LLC
Limited liability has its limits
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.
Company life depends on members
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.
Hard to transfer ownership
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?
How to register your business as an LLC
These are the main steps involved in setting up a limited liability company.
- Choose the state you want to set up your LLC - You can register your LLC in any state including a different state from where you will be operating. However, this also means you will have to register as a foreign LLC in the state where you want to operate which means more paperwork and more fees to pay.
- Choose a unique business name - The name you pick for your company should not already be registered to another business in your state or any other state you wish to operate from. Do research in online directories, county clerk’s office, and secretary of state’s website to ensure your business name does not already exist.
- Have a registered agent - Each state requires that you fill in a registered agent’s name and address on the forms that you will submit to the secretary of states’ s office to legitimize your LLC. A registered agent is a person you select to receive official business correspondence like legal documents, notices, and tax documents for your LLC. If your company is being subpoenaed or is being sued, the registered agent is the person that receives the associated notices. And while a member of your company can serve as a registered agent the wiser decision is to use the state-approved third-party companies that offer registered agent services.
- File your LLC with your state - This is the step where you submit your company’s formation documents to the government. These documents are known as Articles of Organization, Certificate of Organization, or Certificate of Formation. Some information that will be required when filing your articles of organization includes business name, business headquarters, and management type. Will your LLC be managed by a member or will you hire a manager?
- Get employer identification number (EIN) - It’s a legal requirement that any business with employees or that’s structured as an LLC has an EIN. This is a nine-digit identification number assigned to businesses for tax purposes.
- Draft an Operating Agreement - This is a document that acts as a guideline for how the business should be run. What is the role of each member in the day-to-day activities of the business, who is the key decision-maker, how will profits be split between members? These are some of the things that need to be addressed in an operating agreement. It’s not a legal obligation but it’s critical to the success of your business. It can be written or it can be an oral agreement.
- Set up a business account - You can still use your personal account for your company but this will make it harder to distinguish between personal and business transactions. There is also the increased risk of piercing the corporate veil.
LLC Taxes: How is an LLC taxed
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.
When to elect the S Corp tax classification as an LLC
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.
When to elect the C Corp tax classification as an LLC
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.
Tips to help you pay less tax for your LLC
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.
Examples of tax-deductible expenses
- Business expenses - All expenses that are necessary to run your business are deductible. These include the cost of raw materials, transportation costs, storage costs, labor costs, and your business startup cost.
- Educational expenses - If, for instance, you took a course meant to help maintain or improve the skills needed to grow your business, the IRS accepts that as an educational expense and allows you to write it off when filing taxes. Other education expenses you can deduct include tuition, books, research costs, and also transportation and travel costs incurred to get the education.
- Healthcare deductions - The IRS allows LLC members to write off expenses such as premiums you paid on a health insurance policy covering medical care or long-term care insurance policy for yourself, your spouse, and dependents.
- Bad business debts - A bad debt is money that you are owed but can’t collect. For instance, if you loaned some money to a client or, sold goods on credit to customers and you are yet to be paid, the IRS accepts that you deduct them from your business income as long as you had included the debts when stating your business income for the year.
How to properly track business expenses and maximize write-offs
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.
Bonsai Tax: How we can help save revenue for your LLC
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.