August 16, 2004
If your business currently operates as a sole proprietorship, changing to an LLC is in your best interest. For a variety of reasons-including the fact that an LLC protects the owners from the debts of and any judgments against the business-it's the preferred form of business organization.
Until recently, the corporate form of business organization provided the only protection to entrepreneurs from the dangers of unlimited personal liability exposure. With the advent of the LLC form, business owners can now enjoy protection from any present and future liabilities or judgments against the business without having to incorporate. Furthermore, as the LLC form developed and became more widely accepted by individual states, the considerable tax benefits of the LLC form became even stronger.
For individual business owners, the LLC offers a one-person LLC form, which is taxed as a sole proprietorship. In addition to offering the owner all-important limited personal liability exposure, the LLC retains important tax benefits of the sole proprietorship, such as: owner compensation in the form of distributions of profit, which are taxed at the individual owner's potentially lower marginal tax bracket (the tax rate applicable to the next dollar of taxable income the owner earns); and pass-through of business losses, offsetting the owner's other nonbusiness income.
For businesses with multiple owners, the LLC form offers similar tax benefits, plus the added advantages of a corporate form. If the owners or members of an LLC do nothing, their LLC will be taxed as a partnership; however, they can elect for their LLC to be taxed as a corporate entity-typically the preferred option. And within that option is another option to elect to be taxed as either an S or a C corporation.
If the owners of the LLC want to keep the business's profits in the LLC in order to facilitate the growth of the business, the preferred option is a C corporation. Under this form, the LLC's profits will only be subject to the beginning corporate tax rate of 15 percent-presumably less than the owner/member's personal marginal income tax rates. And if any of the LLC's owners/members want to receive compensation, they can be paid W-2 wages for their business-related work
If, on the other hand, the owners of the LLC want to take all or some of the profits out of the business, the preferred election is an S corporation. Each owner or member can receive his or her pro rate share of the LLC's total bottom line profit as distributions of profit (taxed at their respective individual marginal income tax rates, but not subject to Self-Employment Tax).
There are a number of additional benefits of an LLC, taxed as an S corporation, over the traditional straight S corporation form of business organization. These additional tax benefits include the ability to have:
- More than 75 business owners.
- A nonresident alien as an owner.
- A corporation or a partnership as an owner.
- More than 80 percent ownership in a separate corporate entity.
- Disproportionate ownership-ownership percentages that are different from each respective owner's investment in the business.
- Flow-through business loss deductions in excess of each respective owner's investment in the business.
- Owners/members that are active in the management of the business without losing their limited personal liability exposure.
You should strongly consider selecting the LLC form of business organization if you are a one-person owner of your business or if you have other business partners. In essence, what this means is that any business owner, given the tax climate created by current IRS tax laws, should be an LLC, either taxed as a sole proprietorship, in the case of one owner, or as either a C or an S corporation when multiple owners exist.
Note: The information in this column is provided by the author, not Entrepreneur.com. All answers are general in nature, not legal advice and not warranted or guaranteed. Readers are cautioned not to rely on this information. Because laws change over time and in different jurisdictions, it is imperative that you consult an attorney in your area regarding legal matters and an accountant regarding tax matters.
David Meier is the founder and COO of Business Development Coaching, which provides small-business owners with ongoing business coaching and the knowledge and support required to enable them to become truly successful entrepreneurs. Visit his site at http://www.makeyourlifetaxdeductible.com .