Learn about the types of business formations that are available when you decide to start your business…
Testimonials – Black Box Franchising
If you are considering starting a business, it is important that you know the types of business formations available along with what will truly be expected of you as you endeavor on your entrepreneurial pursuits. In this discussion TheWealthIncreaser.com will discuss the various types of business structures available and the requirements that you will be expected to meet as you pursue your entrepreneurial dreams.
Although the creator of TheWealthIncreaser.com has not written an article in over a month and is dusting off rust to a degree, this discussion will be presented from an angle that you can hopefully readily understand and will hopefully help ensure a more prosperous PATH toward your wealth building goals as you form your new business.
Keep in mind that this blog post is longer than most created by TheWealthIncreaser.com, so be sure you have at least 20 to 30 minutes set aside so that you can interpret and comprehend this discussion at your highest level–as by doing so you can put yourself and your family in better position for long-term wealth building success.
Sole Proprietor
A sole proprietorship is the simplest business formation and is a form of ownership where you act as the sole-owner. You would file your business return on schedule C on your personal tax return if you found it more advantageous to do so or you wanted convenience and simplicity in filing your return.
In essence your net income or loss would pass through to your personal tax return from the schedule C and you would be taxed at the appropriate rate depending on where you fall in the tax brackets (can range from zero to thirty-seven percent generally speaking).
NOTE: For tax year 2022, the top tax rate remains 37% and all of the rates are based on your Adjusted Gross Income (AGI) and not your Gross Income:
Marginal Rates:
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Tax brackets for income earned in 2022
- 37% for incomes over $539,900 ($647,850 for married couples filing jointly)
- 35% for incomes over $215,950 ($431,900 for married couples filing jointly)
- 32% for incomes over $170,050 ($340,100 for married couples filing jointly)
- 24% for incomes over $89,075 ($178,150 for married couples filing jointly)
- 22% for incomes over $41,775 ($83,550 for married couples filing jointly)
- 12% for incomes over $10,275 ($20,550 for married couples filing jointly)
- 10% for incomes of $10,275 or less ($20,550 for married couples filing jointly
Married filing separately pay at the same rate as unmarried. Source IRS
As a pass-through entity you would be eligible for the 20% exclusion of income (Qualified Business Income) that was passed in the tax cuts and jobs act of 2017.
You would report the income that you earn directly from your business activities on the schedule C, including income that you earn from 1099 income. You would also pay self-employment taxes if your earnings exceeded $400. You would pay 15.3 percent in self-employment taxes and you would be able to deduct 7.65 percent or one half of your self employment taxes on your personal tax return–thus bringing your effective self-employment tax rate down to 7.65% of your earnings from your business. Your self employment taxes that you pay would be a part of your social security contributions.
The major disadvantage of a sole proprietorship is that you would have unlimited personal liability as the owner–and depending on your tax bracket and your net income possibly pay more in taxes than you would as a corporation.
If you desire to form a business utilizing rental properties you cannot utilize schedule E where you act as the sole-owner of actively managed real estate where you provide “substantial services” as you would have to include that income on schedule C of your 1040. You would file your business return on schedule C on your personal tax return if you had rental properties and you offered substantial services beyond what is normal such as electric, gas, trash and the like. If you offered breakfast and cleaning services on a regular basis you would possibly be offering substantial services and you would need to file schedule C instead of schedule E.
If you are considering rental activity as a business you want to be aware of what to expect on the front end. Schedule E and Schedule C is often used to report rental income and expenses at the individual level.
Schedule E is also used to report income for individual partners in a partnership and for owners of S corporations. The income of the business for the year is calculated and the profits or losses are distributed to the owners in the form of a Schedule K-1. This information on the individual owner’s income or loss is included in Part II of Schedule E.
However, Schedule E is not used to report rental real estate activities for partnerships and S corporations. Instead, partnerships or S corporations would use IRS Form 8825 to report rental real estate income and expenses and the income and expenses would pass through from the form 8825 to the partners and owners.
In short, individually a partner or shareholder would use schedule E Part II, however for the partnership form 1065 and form 8825 would be used and for the S corp form 1120S and form 8825 would be used to report real estate income and expenses (along with k-1s).
Providing substantial services and being considered a business owner also means you must pay self-employment taxes on income that is earned from the rental activity!
If you are running a home-sharing business with no substantial services provided, you would use Schedule E to report your rental income and expenses. If your home sharing type business involves substantial services (like breakfast or transportation), it would normally be taxed as a business, using a business tax form depending on your business type.
In many cases it can be difficult to determine the status of an individual tax situation where rental activities are involved as each individuals situation is unique. If you are starting in a business involving residential real estate or a home sharing type of business, get advice from your tax professional, CPA or tax attorney about your tax status.
If you had rental property and did not offer substantial services, your net income or loss would flow from the schedule E on your personal tax return and you would be taxed at the appropriate rate.
By using a schedule E or schedule C you could hold assets and deduct expenses on your personal tax return.
Always realize that there are two versions of Schedule K-1: Schedule K-1 (Form 1065) for Partner’s share of income, deductions, credits, etcetera, and Schedule K-1 (Form 1120-S) for Shareholder’s share of income, deductions, credits, etcetera. It is important that you are able to distinguish between the two versions–depending on your current business type or anticipated business type.
If you decided to start a farm, you could file on schedule F on your personal tax return, or you could elect to choose a business structure listed below. In general, the same concepts as discussed above for filing a schedule C would apply to your farm income if you filed a schedule F, however there are some differences (advantages and disadvantages) that you would want to educate yourself on if you have a farm or anticipate creating one in your future and you are considering filing as a sole proprietorship or other business form.
In closing, sole proprietorship is the simplest structure for a one-owner business, as there are very few regulatory issues and you can exert direct control and discretion in many facets of the business.
As a sole-owner there’s no legal liability limits between the business’s assets, debts and other liabilities and those of the owner–therefore you would or could directly be liable for any legal or financial failures of the business (you would have unlimited personal liability as the owner).
Partnership
Partnerships file an information return 1065 to report their income, gains, losses, deductions, credits, etcetera.
If you were an employee of a partnership, you would personally pay half of the 15.3% in payroll taxes, a small FUTA tax, and personal income taxes on that salary. Your business pays the other 7.65% in payroll taxes which can then be written off as a tax deduction by the business. The rest of the company profits you earn could be taken as “distributions” which aren’t subject to payroll taxes.
What are distributions you ask?
Distributions are money that you personally take out of your business by cutting yourself a check or transferring money to your personal account.
Your distributions aren’t treated like self-employment income!
Another thing to consider is that when you have a partnership, the tax filing deadline is March 15, not April 15, and the penalties are much higher if you do not file your tax return on time.
When it comes to liabilities and taxes partnerships are similar to sole proprietors, mentioned above. As a partner of a “general partnership” you would report your share of income, expenses, credits, profits and losses on your personal tax return.
You would pay taxes at your personal income tax rate and have exposure of the business’s liability(s) as personal liability(s).
Also similar to sole proprietors, as a partner you must pay a self-employment tax, where applicable, on all gains without the benefit of separately categorized distributions that could possibly go un-taxed if you were to form an LLC and you elected S corp taxation.
A limited partnership (LP) or limited liability partnership (LLP) may be considered depending on the industry and other specifics of your business and they would provide you protection against your personal assets.
If you decide to file as a partnership, it is “very important” that you create a Partnership Agreement to set out the formalities of the business.
A partnership can be set up as a “general partnership” or a “limited partnership” and the taxes would pass through from the 1065 and schedule k to the partners so that the income or losses could be reported on the personal tax returns of the partners so that taxation could occur based on the marginal tax rate of each partner.
If the partnership suffered a loss during the tax year the losses would flow to each partner based on their partnership interest.
In essence, the net income or loss from the partnership would pass through to your personal tax return if you decided to form a partnership (along with your tax partner(s) tax return) and you and your partner(s) would be taxed at the appropriate rate depending on where you fall in the tax brackets (can range from zero to thirty-seven percent of your AGI, generally speaking).
And similar to a sole-proprietor, as a pass-through entity you would be eligible for the 20% exclusion (QBI deduction) that was passed in the tax cuts and jobs act of 2017.
You would report your portion of the pass-through income from your k-1 on the schedule E . You would also pay self-employment taxes if your earnings exceeded $400 and pay 15.3 percent in self employment income tax and you would be able to deduct 7.65 percent or one half of your self-employment taxes on your personal tax return–thus bringing your effective self-employment tax rate down to 7.65% of your earnings over $400. Your self-employment taxes would be credited toward your social security contributions.
Limited Liability Company
- Forming an LLC gives legal protection to your personal assets and doesn’t affect your taxes if you file as a corporation compared with operating as an individual or independent contractor.
- Electing S Corp taxation could reduce the amount of income you pay self-employment tax on.
The formation of a Limited Liability Company, or LLC, can in many cases be a great way to organize your company and protect yourself from liability. The key question that you need to ask when considering an LLC is how you would pay yourself if you were to choose an LLC as a form of ownership?
The two most common options for paying yourself are to treat yourself as an employee with wages, or to treat yourself as an LLC member and receive distribution from the profits.
When there are multiple owners, if all of the LLC members participate equally in the operation of the business, you can’t pay one a salary and not the others.
However, if you are the only member that has a management role, you can pay yourself a salary without setting up salaries for the other participating LLC members!
Related: (Starting a Limited Liability Company Online)
1) Paying Yourself as an Employee with Wages
Employee wages are considered operating expenses for the LLC and would be deducted from your LLC’s profits.
The Internal Revenue Service (IRS) only allows reasonable wages as a deduction, so be sure any salary you pay yourself is within industry norms.
You can also issue bonuses to LLC members who are employees, including yourself. Bonuses must also be reasonable and related to the salary being paid.
You’ll need to file IRS Form W-4 to determine the amount of payroll withholding from each paycheck you receive.
The LLC will pay you as a W-2 employee and will withhold income and employment taxes from your paycheck. You will pay income tax on your wages earned. You will in almost all cases need to have a payroll company manage your payroll so that you can free yourself up to run the business more effectively–and efficiently. The W-2 income that you receive would be deductible by the LLC on your personal tax return on schedule C.
You can use the employee option if you are a sole proprietor, partnership, S corporation or C corporation.
2) Receiving Distributions from LLC Profits
You also have another option for how to pay yourself in an LLC and that option is to receive distributions of profits from your LLC each year.
In general, if you have a multiple member LLC, each member owns a percentage of the LLC, called the “capital account” that can be drawn from.
Year-end profit distributions are made based on that percentage.
Let’s say that the LLC that you create had $100,000 in profit and you had one other member, you would each own 50%, therefore, you can each receive $50,000.
You also could set up a draw to receive ongoing payments as a draw against the year-end profit.
If you expect your percentage of the year-end profit to be $24,000, you could set up a draw to receive $1,000 each month along with $1,000 for the other member assuming they owned 50%.
The total of all the draws throughout the year are deducted from the total year-end profit!
So if your draw for the year totaled $12,000, but your share of the profit ends up being $15,000, then you would receive $3,000 at the end of the year.
If you are the only member of the LLC, you will pay income tax on “your distributions” and you will file Schedule C to report the profits and losses of the LLC with your personal tax return.
If there is more than one member, the IRS generally treats the LLC as a partnership and each member would report their share of the profit and pay income tax and self-employment tax on that profit.
The LLC will file IRS Form 1065 (information return) to report how profits are divided among the members and individual members would receive a schedule k.
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NOTE: It’s important to note that receiving a salary and receiving year-end distributions are not mutually exclusive. If you get a paycheck, you’re still a member of the LLC and you are entitled to your year-end distribution.
Work as an Independent Contractor
Another potential option for paying yourself is to hire yourself as an independent contractor, doing work for the LLC that you also own.
Let’s say you are a member of an LLC that offer a food service, you can hire yourself as an independent contractor to provide the service. This type of arrangement may not offer as many benefits, though–so use caution.
If you choose to pay yourself as a contractor, you need to file IRS Form W-9 with the LLC and the LLC will file an IRS Form 1099-MISC or 1099 NEC at the end of the year and you would receive a copy during the tax season–usually by January 31st.
You will be responsible for paying federal, state (if applicable) and self-employment taxes on the amount earned.
Choose Not to Receive Payments
You also have the option to not pay yourself anything and to leave the profits in the LLC.
You still need to pay income tax on the profit earned, since the profits from your LLC pass through to your personal tax return or would be included on your corporate return if you elected to be taxed as a corporation.
How to Form an LLC
To form an LLC, you need to name your limited liability company, selecting a name that is not in use by another business in your state.
The secretary of state website in your state will generally link to the database where you can search names.
Once you’ve chosen a name, you can start an LLC by designating a registered agent, a person or company that is authorized to do business in your state.
The registered agent is who will receive legal notices such as service of process and tax forms on behalf of your LLC.
You can designate yourself in some states, but it is generally best to choose a company that specializes in providing this service.
You must also file a formation document with your state, typically called “articles of organization” and pay a fee.
Once your state accepts your articles of organization, you have officially formed an LLC and you want to be prepared to pay an annual fee in order to keep your LLC in good standing with the state and the public on a year-to-year basis or for the life of your LLC.
In Summary:
a Limited Liability Company (LLC) is a business structure allowed by state statute.
Each state may use different regulations, you should check with your state if you are interested in starting a Limited Liability Company.
Owners of an LLC are called members and most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities.
There are no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner.
A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information.
Always realize that there are special rules for foreign LLCs.
Taxation of LLC’s can be as a sole-proprietor (default), partnership (agreement and/or default), S corporation (election) or C corporation (election).
C Corp or S Corp
As an LLC you can choose to identify as either an S corporation or a C corporation.
S corporation
If you select an S corporation, income is reported by the LLC but is passed through to you and other shareholders as owners. You report that income but do not pay self-employment tax as a partnership or sole-proprietor would.
You want to ensure on the front end that you are eligible for S corp election!
A single-member LLC taxed as an S Corp splits up that income and tax burden. As an S Corp owner, you must pay yourself a salary, which has to be “reasonable compensation,” – similar to what you’d make as an employee performing the same job.
Other key aspects of an S corp:
What is the S Corp tax rate?
An S corp would file 1120S information return. As a pass-through entity your share of income would flow from the 1120S to you and you would pay taxes based on your marginal tax rate that was discussed above. An S Corp does not have a separate income tax rate like a C corporation as it is considered a pass-through entity, meaning profits are passed through to the owner (possibly you if you elected this type of business formation) and taxed as personal income based on the owner’s tax bracket, thereby qualifying you for the QBI deduction if you were otherwise eligible.
Does an S Corp file a tax return?
Yes, information return on Form 1120S would be filed.
A corporation must file Form 1120-S if it elected to be an S corporation by filing Form 2553, and the Internal Revenue Service (IRS) accepted the election. The IRS uses the ownership percentage detailed in Form 1120-S to allocate how much profit and loss should be assigned to an individual shareholder.
Even though the S corporation does not pay income tax, it has a responsibility to file an annual tax return on Form 1120S. This tax form is for informational purposes only and provides the IRS with an aggregate view of the business’ earnings and expenses.
Can I change from an LLC to an S Corp?
In order to receive S Corp tax status you must first form an LLC and later determine if S corp election is an option for you–and if so consider the pros and cons based on your business type and expected earnings.
The S corp election process varies from state to state, but involves:
- selecting a business name
- filing an articles of organization
- selecting a registered agent, and
- creating an operating agreement.
There also may be associated fees, such as the articles of incorporation fee if you were to elect to be taxed as a corporation.
After incorporation as an LLC and you meet the requirements (such as having less than 100 shareholders) you can then file form 2553, “Election by a Small Business Corporation” and if accepted would allow you to be taxed as an S corp for tax purposes with the IRS.
The process is fairly efficient and in most cases can be completed in a few business days.
Once your business receives S Corp status, you can continue to enjoy the benefits of the owner of an LLC such as “limited liability protection” with the potential added tax benefits of an S corporation.
Again, S-corps are exempt from a federal corporate income tax! You file 1120S for informational purposes (the IRS wants to know who to expect tax payments from and at what amount).
In summary, S-corp taxation isn’t just for corporations as LLCs that meet eligibility requirements can also elect to be taxed as an S-corp.
By default, LLCs are taxed like sole proprietorships or partnerships, meaning the owners are considered self-employed and pay self-employment tax on all business profits.
S-corp shareholders can be company employees (rather than self-employed), reporting both a salary and distributions (draws that were discussed earlier) from company profits.
S-corp shareholders only pay self-employment tax on the salary component of income, while distribution income isn’t subject to self-employment taxes.
Keep in mind that if you elect S-corp status, you may receive extra scrutiny from the IRS, especially when it comes to the allocation of income between distribution and salary.
Salaries paid to S-corp shareholders must be reasonable, and not lower than the average or norm for the industry in order to avoid taxes. Be sure you keep good records.
C corporation
As a C corporation you will also file corporate tax returns. You will also personally file taxes and pay tax on your dividends, which are not tax-deductible for the LLC, so you end up paying a double tax on that income (once as the LLC on corporate return and once on dividends on your personal tax return).
To contrast with an S-corp, C-corp shareholders are not allowed to write off corporate losses to offset other income on their personal income tax return
These shareholders still pay personal income tax on dividends taken home (at their own bracket’s marginal rate) but only after the corporation’s gains have been taxed at the corporate income tax rate (currently 21%). This arrangement is referred to as “double taxation” and you may be aware of the phrase. Double taxation has historically been viewed as the price to pay for a corporation’s limited liability advantages that they have enjoyed for years.
As far as the complexity spectrum goes, C Corps have the most filing and maintenance restrictions, LLCs the least.
While S-corps and C-corps are usually not any different under state corporation laws, the important differences lie in federal tax law.
With a C-corp, a corporate income tax is paid first with a federal return (Form 1120) required by the IRS.
Shareholders must then pay taxes on personal income at the individual level for any gains from dividends. In exchange for this less favorable double taxation, C-corporations enjoy an absence of restrictions on who can own shares.
Unlike S-corps, C-corps can have an unlimited number of shareholders and can include businesses and entities both inside and outside the United States.
If you choose to start or change your business to a C corp, you must file Articles of Incorporation.
By contrast, if you choose to establish an LLC, instead of filing Articles of Incorporation like a corporation, you must file Articles of Organization with whatever state agency manages business registration.
And similar to an LLC, a C corporation must also list a registered agent.
About Form 1120, U.S. Corporation Income Tax Return | Internal Revenue Service (irs.gov)
Form 1120
Can I Consider a Single Member LLC, even if I am Married
The money earned from an LLC flows through 100% to your personal return where you and your spouse (if you are married) file jointly, therefore it is sometimes easier to just form an LLC using just one spouse in the marriage in a “single-member LLC” where only one spouse would be credited with self-employment tax payments.
A single-member LLC is taxed as a sole proprietorship, unless an election is made!
That means you pay a 15.3% FICA tax –commonly referred to as self-employment tax – on all the taxable income you earn from your business.
You also pay personal income tax at a rate determined by your tax bracket..
Generally the IRS considers married couples in an LLC to be a partnership.
By forming a business with your spouse you could potentially open up other potential tax-saving opportunities.
For example, you and your spouse may then be able to contribute more toward retirement, through the payment of self-employment taxes and other tax favored accounts. Other additional expenses that you may now take for granted can also possibly be deducted as business expenses.
Also, forming a business with a spouse could possibly open the door for the business to take advantage of several government programs aimed at helping protected classes of individuals.
If a single-member LLC does not elect to be treated as a corporation, the LLC is a “disregarded entity,” and the LLC’s activities should be reflected on its owner’s federal tax return. If the owner is an individual, the activities of the LLC will generally be reflected on:
An individual owner of a single-member LLC that operates a trade or business is subject to the tax on net earnings from self employment in the same manner as a sole proprietorship.
If the single-member LLC is owned by a corporation or partnership, the LLC should be reflected on its owner’s federal tax return as a division of the corporation or partnership.
State of Georgia LLC Formation (Check with Your State for Requirements)
Advantages & Disadvantages of an LLC:
Limitation of Liability
LLC advantages: LLC owners, also called members, are not personally liable for the debts of the business, including debts from most lawsuits against the company. A creditor of the business cannot go after a member’s personal assets (home, car, bank accounts, etc.).
A corporation and a limited liability limited partnership (LLLP) also afford limited liability, but the LLC has other advantages that will be discussed below.
A limited partnership (LP) protects the limited partners, but not general partners who create and run the business.
Sole proprietors or partners in a “general partnership” have no protection from business debts!
Tax treatment
LLC advantages: For federal tax purposes, an LLC has the most flexibility as to how it’s taxed.
1) A single-member LLC can choose to be taxed as a sole proprietorship, an S corporation, or a C corporation.
2) An LLC with two or more members (a multiple-member LLC) can choose to be taxed as a partnership, an S corporation, or a C corporation.
The best choice for you is best made in consultation with a tax expert, CPA and/or tax attorney!
A sole proprietorship or any version of a partnership has no taxation options unless an election is made:
The taxation would be on your personal tax return–schedule C.
A corporation only has two choices:
1) S corporation or
2) C corporation
S corp election
Unless C corporation treatment is elected, all Georgia LLC profits are passed through to the members. The members pay federal income and self-employment tax on their share of the profits, even if they do not actually receive any profits.
An LLC electing C corporation taxation pays federal corporate income tax, and the members pay tax on any profits (dividends) that are actually distributed to them—this is commonly known as double taxation.
Registered Agent
A registered agent is a person or company that is designated to receive official legal documents for a business, such as lawsuit papers, subpoenas, and wage garnishments.
Hiring an outside registered agent will generally cost from $100 to $500 per year, depending upon the agent you hire.
A registered agent is also required for corporations, LPs, and LLLPs. There is generally no advantage to having a registered agent, although it may be a convenient way to be sure legal documents are received and handled properly.
An LLC is more expensive than a sole proprietorship or general partnership, since neither of these other types of businesses is required to register.
Unlike a sole proprietorship or general partnership, an LLC is required to have a registered agent in a similar manner as a corporation.
Ability to Raise Capital
LLC advantages: A n LLC may find it easier to raise investment capital than if it were structured as a sole proprietorship or general partnership.
Neither of these other forms of business can take on investors without making them a partner, but it is possible for an LLC to add new members without giving them a full role in management.
LLC disadvantages: If an LLC elects C corporation or S corporation taxation, it will be subject to both Georgia’s corporate income tax and net worth tax.
The corporate Georgia LLC tax rate is six percent of Georgia taxable income.
It is payable by the LLC if C corporation status is elected, and by the members if S corporation status is elected.
The net worth tax is also assessed, if the net worth of the LLC is more than $100,000.
LLC disadvantages: Registration costs An LLC involves more complexity than a sole proprietorship or general partnership, neither of which are subject to state registration requirements.
The Georgia LLC registration cost is $100 for the first year, and $50 per year thereafter, the same as for a corporation, LP, or LLLP.
Unlike a corporation, an LLC cannot issue shares of stock. Any new investor would need to become a member of the LLC, which is more complicated.
Furthermore, many outside investors consider LLCs risky, and prefer to invest in corporations!
Also, banks and other lenders may be more reluctant to loan directly to an LLC than they would to a corporation!
Members of the LLC may be required to personally guarantee a loan, which eliminates the personal asset protection as to such loans. However, lenders may also require a personal guarantee from the owners of a small start-up corporation.
The Georgia Secretary of State corporations website provides additional information that may help you determine the best structure for your company. Also, to ensure a smooth registration process, you may want to consider having the assistance of an online services provider and if you are in another state or Country check with your government corporation website.
Flexible Ownership
LLC advantages: There are no restrictions on the number of members of an LLC, whereas an S corporation is limited to 100 members.
A C corporation can have more members, but will be subject to double taxation and more regulation regarding its operations.
An LLC is more expensive than a sole proprietorship or general partnership, since neither of these other types of businesses is required to register.
Complexity
LLC advantages: A C corporation has a three-tiered management structure, with:
- shareholders
- a board of directors, and
- officers
An LLC may be managed by its members, or by managers selected to run the day-to-day operations.
Corporations must hold an annual meeting of the shareholders, hold board meetings, and keep minutes of those meetings.
There is no requirement for the members of an LLC to conduct meetings and maintain minutes.
LLC disadvantages: An LLC involves more complexity than a sole proprietorship or general partnership, neither of which are subject to state registration requirements.
Other Key Issues When Forming an LLC
Classifications
Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”).
Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation.
For income tax purposes, an LLC with only one member is treated as an entity disregarded as separate from its owner, unless it files Form 8832 and elects to be treated as a corporation. However, for purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.
Effective Date of Election
An LLC that does not want to accept its default federal tax classification, or that wishes to change its classification, uses Form 8832, Entity Classification Election, to elect how it will be classified for federal tax purposes. Generally, an election specifying an LLC’s classification cannot take effect more than 75 days prior to the date the election is filed, nor can it take effect later than 12 months after the date the election is filed.
An LLC may be eligible for late election relief in certain circumstances. See About Form 8832, Entity Classification Election for more information.
If an LLC is owned by a husband and wife in a non-community property state the LLC should file as a partnership.
However, in community property states you can have your multi-member (husband and wife owners) and that LLC can get treated as a SMLLC for tax purposes.
If you are married and live in one of the nine current community property states: Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico and Wisconsin. Within these states the law states that all property acquired by a married individual is owned in common with the individual’s spouse.
These very same laws can be extended to profits from an LLC that is owned solely by two people married to each other.
Taxpayer Identification Number
For federal income tax purposes, a single-member LLC classified as a disregarded entity generally must use the owner’s social security number (SSN) or employer identification number (EIN) for all information returns and reporting related to income tax.
For example, if a disregarded entity LLC that is owned by an individual is required to provide a Form W-9, Request for Taxpayer Identification Number (TIN) and Certification, the W-9 should provide the owner’s SSN or EIN, not the LLC’s EIN.
For certain Employment Tax and Excise Tax requirements discussed below, the EIN of the LLC must be used. An LLC will need an EIN if it has any employees or if it will be required to file any of the excise tax forms listed below. Most new single-member LLCs classified as disregarded entities will need to obtain an EIN.
An LLC applies for an EIN by filing Form SS-4, Application for Employer Identification Number. See Form SS-4 for information on applying for an EIN.
A single-member LLC that is a disregarded entity that does not have employees and does not have an excise tax liability does not need an EIN. It should use the name and TIN of the single member owner for federal tax purposes.
However, if a single-member LLC, whose taxable income and loss will be reported by the single member owner needs an EIN to open a bank account or if state tax law requires the single-member LLC to have a federal EIN, then the LLC can apply for and obtain an EIN.
Employment Tax and Certain Excise Tax Requirements
In August, 2007, final regulations (T.D. 9356) were issued requiring disregarded LLCs to be treated as the taxpayer for certain excise taxes accruing on or after January 1, 2008 and employment taxes accruing on or after January 1, 2009. Single-member disregarded LLCs will continue to be disregarded for other federal tax purposes.
A single-member LLC that is classified as a disregarded entity for income tax purposes is treated as a separate entity for purposes of employment tax and certain excise taxes. For wages paid after January 1, 2009, the single-member LLC is required to use its name and employer identification number (EIN) for reporting and payment of employment taxes. A single-member LLC is also required to use its name and EIN to register for excise tax activities on Form 637; pay and report excise taxes reported on Forms 720, 730, 2290, and 11-C; and claim any refunds, credits and payments on Form 8849. See employment and excise tax returns for more information.
Note: If an LLC is owned by husband and wife in a non-community property state, the LLC should file as a partnership. LLCs owned by a husband and wife are not eligible to be “qualified joint ventures” (which can elect not be treated as partnerships) because they are state law entities. However, one spouse can form an LLC and be treated as a sole owner or elect to be treated as a corporation. For more information see Election for Husband and Wife Unincorporated Businesses.
Since Limited Liability Companies have exploded over the last 30 years or so, it has been covered in more detail in this discussion than other business formation types due to its popularity among start-up companies and small businesses.
The key aspects of an LLC include:
- Shields you from debts and liabilities of your business—liabilities limited to assets within the company
- LLCs and S-corps avoid double taxation and pass-thru taxation—flow from the business to your personal taxes
- LLC can be used to hold assets or run a business
- LLC is created by secretary of states office
1) statement of formation—select officers, president, vice-president, treasurer, secretary and define members ownership percentage—if you do business in another state you will need to register in that state
2) Steps vary by state
3) you must keep information and payments current with your state and some states require that you file annual reports
LLCs have members and managers
Aways make it a priority to stay in “Good Standing” as businesses and individuals will check before doing business with you
4) Operating Agreements formalize and sign—governs purpose, management, decision making, capital contributions and profits and losses of the company—how to transfer and add members would also be addressed here—along with what happens at death of a member and dissolution of the company (LLC).
Be sure to include: purpose, address of LLC, state where formed, address of company and address of registered agent
Term—30 years in GA-other states vary or you set—must dissolve with state otherwise you may owe fees and be in violation of mandated filing requirements
Management—member managed—actions taken by formal resolution and run by majority vote of members versus manager managed by management team—each manager can bind the LLC
Members & Membership Provisions—titles and ownership percentage listed here—how new members join—how transfers occur—state that members will not be liable for the debts and liabilities of the LLC in the due course of business—state what members are not allowed to do with money and property of LLC
Enter into contracts, convey, sell, assign contracts, transfer, pledge or encumber property or Intellectual Property of LLC
Accumulate debt or make promise to pay creditors
Approve or enter into a judgement on behalf of LLC
Borrow money in the name of the LLC
5 Steps that You can Take when Forming Your LLC (You May Need an Attorney or other Professionals to Assist You):
1) Step One: Determine Ownership Percentages
2) Step Two: Designate Rights, Responsibilities, and Compensation Details
3) Step Three: Define Terms of Joining or Leaving the LLC
4) Step Four: Create Dissolution Terms
5) Step Five: Insert a Severability Clause
Be sure to determine the following prior to creation:
Capital Contributions—how much each member will contribute
Allocation of profits and losses:
How calculated—when distributed—what happens in event of losses—how allocated
Accounting—when taxable year ends—cash or accrual –taxed as a partnership or corp.—elect S-corp or C corp review
Dissolution—finite or open ended—capital distributed according to operating agreement after death dissolution
Must be a separate entity—you cannot commingle funds with your personal accounts
Adequate assets—must fund appropriately—fund should be contributed to start-up capital
Separate Assets—own LLC bank account—hold title to assets in own name—can’t use to pay personal expenses or investments of members—TRANSFER OF CASH SHOULD ONLY BE FOR REASONABLE COMPENSATION BY MEMBERS THAT HAVE BEEN AGREED UPON IN ADVANCE—FOR REIMBURSEMENT FOR REASONABLE EXPENSES INCURRED ON BEHALF OF THE LLC AND DISTRIBUTIONS ALLOWED UNDER THE terms of the operating agreement.
For Example, a distribution to a member to pay income taxes or designation that a member can lease an office or equipment and should be written into lease.
Separate Operations:
- Do not commingle your personal accounts with your business account of the LLC
- Keep member accounts and personal transactions separate from the LLC
Taxation:
- Disregarded Entity pass thru is default—pay is reasonable value of your services
- form 2553 s corp election you would have payroll earnings—not pass thru
- form 8832 entity classification then form 2253
Relevant Forms & Documents that You May Need to Start Your Business
EIN—a number that you get as a new business owner after you form a company
I-9—established the independent contractor’s ability to be hired in the United States
W-9—Social Security Number or Tax ID number needed so that vendor or business can report your income that you receive as an independent contractor to the IRS or if you are paying a vendor over $600 for the year you will want to get a completed W-9 so that you can file payments over $600 to the IRS
1099—shows the amount of compensation paid to the independent contractor that you pay or that is paid to you if you are acting as an independent contractor
1096—You or your business would group all of your 1099 payments to independent contractors or vendors on this form and submit to the IRS so that you can stay in good standing with the IRS (your records of payment to independent contractors/vendors and the IRS records would be in congruence)
W-4—Determines the amount of allowances that are selected for tax withholding purposes for employees of your business–allowances are generally based on filing status, number of dependents and anticipated tax credits and deductions
W-4p—Retirees who worked at your company would receive this for income tax reporting purposes
W-2—shows and reports to IRS employee income for the year and taxes withheld
DUNS # (Dun & Bradstreet)–will help with business credit, financing and vendor relations
Payroll–You will need to select a company to handle your payroll if you hire employees
Considerations:
Hourly versus salary
Taxes
Social Security & Medicare (FICA)
FUTA Federal Unemployment Taxes—6% on the first $7,000
SUTA—State Unemployment Taxes varies by state—paid every time you run payroll
State Sales Tax–depends on your business
Insurance--you will need to select a company to handle your insurance needs
Considerations:
Crisis Insurance—stand alone policy or add-on on E & O or Liability policy
Professional Liability Insurance (Malpractice, Errors & Omissions etc.)
Liability Insurance
Business Insurance
Business Interruption Insurance
Workers Comp–Pays for medical bills and wage replacement for a worker who is injured on the job
SUTA–Unemployment Insurance—state fund that employer’s pay into through payroll
FUTA–Unemployment Insurance—Federal fund that employer’s pay into through payroll
Disability Insurance—many employer’s provide or you can purchase a policy yourself if you are an employee
Key Person Insurance—basically life-insurance that would benefit your company for continued operation (the company is the named beneficiary on the policy)
Legal Protection
Copyright, Patent, Intellectual Property and other legal protections of your works, products or services may be needed
Copyright.gov–-life of author plus 30 years–$35 per work submitted—can register multiple works if created at same time
If your business has patents, intellectual property etcetera, it is best to consult with an attorney
Conclusion
It is important that you realize that starting a business regardless of the formation type is a serious endeavor and you must be aware on the front end of what is required of you. By gaining an understanding of the various business formation types at this time you can plan better and ensure proactively that you have all of your I’s and dots covered–so to speak.
Starting a business is a major decision and one that should not be entered into without having an understanding of the topics that were discussed above prior to going into business. By proactively gaining a business mindset you can help ensure that you are making the right or at a minimum good decision as you pursue your dream of business ownership.
Many small business owners choose LLCs for simplicity and flexibility and eventually elect S-corp status or C-corp status once their earnings improve, rather than first registering as a corporation.
In addition, if you are properly funded and operate the right business you can form your business out the gate as an S corporation or a C corporation if you and your professional team see it more advantageous to do so.
There is no one best option among the possible business structures and tax treatments as each business will have a unique profile. Your choice should be based on the specific situation of your business and projected earnings.
As a potential business owner you should consult with legal and tax professionals during the business formation process!
Regardless of your business formation, it’s important to have a basic understanding of your options upfront and you must also remember that many businesses evolve from one business structure to the next as they grow over time.
You now know that in order to establish an LLC, instead of filing Articles of Incorporation like a corporation, you must file Articles of Organization with whatever state agency manages business registration in your state.
And just like a corporation, an LLC must also list a registered agent.
Always make it a point to operate your business regardless of formation type with integrity (ensure that your behavior matches your beliefs) as by doing so you will make your companies continued growth much more likely to occur.
Your PATH to business and wealth building success requires that you participate in the right activities, associate with the right people, think about the right things and form the right habits that are necessary so that you can achieve on a consistent basis so that you can finish among the top in all of your races.
Always realize that you can always change your PATH toward the success that you desire–and you can always reach higher!
All the best to starting your business and continuing on a path to achieving a lifetime of success…
Note: This page is not to be interpreted as legal advice by the author but is presented primarily so that you are aware of legal structures that are available when you contemplate forming a business entity.
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