Limited Liability Company Tax Advantages and Disadvantages

If you have an LLC, it’s important to understand that there are many Limited Liability Company tax advantages and disadvantages.

If you are a small business owner, you have the option of running it under many different legal forms. One of those forms is an LLC or Limited Liability Company. This election has a number of different advantages and disadvantages from a legal and tax perspective. How do you know if a small business LLC is a good idea? First, understand that the tax and liability issues are separate. Let’s take a look at the tax angle first from a federal IRS standpoint.

The IRS doesn’t have tax brackets for LLCs because it doesn’t recognize that form. If you operate your business as a sole proprietor now and decide to form an LLC to protect yourself from liability, you’ll still be taxed as a sole proprietor. (And you still need small business liability insurance of course.) If you currently operate your business as a partnership, you can form an LLC. But you’ll still be taxed as a partnership on the federal level. States tax LLCs differently depending on which state you live in. That’s why it’s always a good idea to consult your local CPA to see what she recommends for your own personal situation.

Other tax considerations:

1. Because limited liability company earnings are taxed as either a sole proprietor or partnership, managing members are subject to self-employment tax. That’s why some people prefer the S Corporation election rather than the LLC.

2. Members get paid using guaranteed payments or profit distributions. Members can’t pay themselves a wage. If guaranteed payments are made, members can quality for tax-favored benefits. Profit distributions to inactive owners don’t qualify them for tax-favored benefit programs like retirement plans.

3. Since this is really a “pass through” organization, if you have an LLC you don’t have to worry about double taxation like some corporation formations do. They have to file a tax return, pay taxes and then make distributions to owners who then get to pay taxes on those distributions.

4. Setting up and maintaining an LLC is much easier than a corporation, which requires lots of paperwork to launch and continue.

Now let’s look at the issue of limited liability. The bottom line is that owners of the LLC, called “members,” are protected from liability for acts and debts of the LLC.

So when is an LLC a bad idea?

Aside from the tax considerations, an LLC can be a bad choice if you want to raise working capital for your company or plan on offering stock options to employees. The LLC isn’t as well understood as the corporate entity, so if you want to borrow money for your company, the LLC may not be the best choice. Also, since the LLC is less prolific, legal firms have fewer templates for the work. As a result, you’ll have higher legal bills if you choose this compared to a corporation.

The bottom line is there are lots of moving parts and considerations. Before making any decision, talk to a legal expert. As an alternative, there are plenty of online firms that can help answer your questions about LLC advantages and help you set it up very inexpensively. One of my favorites is Legal Zoom.