Question:
I am considering creating an LLC for my business but don’t understand how it and I would be taxed. Will you explain?

Answer:
With a Limited Liability Company (LLC), you have a tremendous amount of flexibility on how the entity is taxed. If the LLC has a single member, the default is for it to be considered a disregarded entity and for the LLC’s income and expenses to become the income and expenses of the LLC member. If the LLC member is an individual, the LLC’s income and expenses would be reported on Schedule C of the member’s Form 1040.

If the LLC has multiple members, the default is for it to be treated as a partnership. As a result, the LLC would have to file a Form 1065 annually and to issue each member a Form K-1 (Form 1065), which would list each member’s share of the LLC’s income and expenses. Each member would then be required to report his or her respective share of the LLC’s income on the member’s tax return.

An LLC can also ELECT to be treated as an S corporation. This requires filing Form 2553 with the IRS by the applicable deadline. If the LLC is treated as an S corporation, the S corporation would file Form 1120-S with the IRS and issue each LLC member a Form K-1 (Form 1120-S). Each member would then be required to report his or her respective share of the LLC’s income on the member’s tax return. The LLC may also issue a Form W-2 to the member of the member is an employee of the LLC.

An LLC can also ELECT to be treated as a C corporation. This requires filing Form 8832 with the IRS by the applicable deadline. In this case, the LLC would file Form 1120 with the IRS and would be taxed on all of its taxable income. The LLC would issue a Form 1099-DIV for dividends paid to LLC members (which would get reported on the members’ tax forms) and a Form W-2 if the member is an LLC employee.

The question of how you want your LLC to be taxed can be a complicated one. If you have any other questions, please let us know.

If you only have one owner in a Limited Liability Company, how is it taxed?

A Limited Liability Company that has only one owner is taxed as a disregarded entity for Federal Tax purposes.

What does this mean? It means that a tax return is not filed at the federal level for the entity itself. Instead, the income and expense items of the entity are included on the owner’s individual income tax return. These items will typically be reported on Schedule C and/or Schedule E, and depend on the type of activity as to which form is used.

One factor that differentiates an S corporation from an LLC is the employment tax that is paid on earnings. The owners of an LLC are considered to be self-employed and, as such, must pay a self-employment tax of 15.3% which goes toward social security and Medicare. The entire net income of the business is subject to self-employment tax.

In an S corporation, only the salaries paid to the employee-owners are subject to employment tax. The remaining income, paid as distributions, is not subject to employment tax under IRS rules. Therefore, there is the potential to realize substantial employment tax savings. Case in point:

Mary owns a print shop. In keeping with the industry standard, Mary decides that a reasonable salary for a print shop manager is $35,000 and pays herself accordingly. Mary’s total earnings for the year are $60,000: $35,000 paid in salary and the remaining $25,000 paid as a distribution from the S corp. Mary’s total employment tax is $5,355 (15.3% of $35,000).

If Mary were the owner of an LLC, she would have to pay employment tax on the entire $60,000, equaling $9,180. But as an S corporation, she realizes savings of $3,825 in employment tax.

One might assume that these savings could be further manipulated by reducing the salary to an extremely low amount and attributing the rest of one’s earnings to distributions—but this would be an incorrect assumption. In practice, the IRS is careful to notice whether a salary is reasonable by industry standards. If it determines a salary to be unreasonable, the IRS will not hesitate to reclassify distributions as salary.

Still, while the potential employment tax savings may make the S corporation an attractive structure for your business, bear in mind that you would then have to deal with the administrative burden associated with payroll tax. The payroll tax is a pay-as-you-go tax that must be paid to the IRS regularly throughout the year, or you will incur interest and penalties. The paperwork alone can be an overwhelming task for someone who is not familiar with it.

Owners of LLCs pay their self-employment tax once a year on April 15 when personal income taxes are normally due. Income tax filings are also relatively easy for the owners of an LLC: A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor; partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.

Employment taxes are just one aspect to consider when choosing an entity type for your business. There is no one, magical entity that works for everyone. The important thing is to consider the operational, legal and tax aspects of each structure as they apply to your unique situation.

The end of tax season is finally upon us.  As you rush to prepare and file your individual tax return by midnight on April 15th, keep in mind these five suggestions for streamlining the process and saving money:

1. File electronically.  Consider filing electronically instead of using paper tax forms. If you file electronically and choose direct deposit, you can receive your refund in as few as 10 days.
2. IRA contribution. It isn’t too late to make a contribution to your IRA and take a deduction for 2008.  Make sure your contribution is made by April 15th and you tell the investment company to consider it a 2008 contribution.
3. Refinancing expenses.  With low mortgage interest rates, the past year saw a flurry of refinancing transactions, as homeowners sought to lock in the lower rates.  If you refinanced a mortgage in 2008, you can deduct the points paid, but you must deduct them over the life of the loan.  If your new loan is a 30-year mortgage, that means you can deduct 1/30th of the refinancing points this year.  It may not equate to much, but don’t throw it away.
4. Check your personal information carefully.  This seems simple, but as the old saying goes, the devil is in the details.  The IRS receives untold numbers of tax returns with simple errors or omissions each year.  So, check your return one last time to make sure your names, social security numbers, addresses and bank information are correct.  Also, make sure to sign the return if you file by mail.
5. File an extension.  If it just isn’t humanly possible to finish your return and deliver it by midnight tomorrow, file an extension.  By filing an extension, you will have six more months (until October 15th) to file your return.  The key, though, is that the extension is for filing not paying.  When filing an extension, you must estimate your total tax liability for 2008 and submit payment for that liability along with your extension request by midnight on April 15th.