If you are creating an LLC, especially one where you will be the sole owner, one important issue you'll need to decide is how you want your LLC to be taxed. If this is your first time setting up a business, you may not have thought this issue out in advance because you've got plenty of other things on your mind. However, it's one of the primary reasons that I always encourage clients who are setting up a business to be sure to meet with and discuss options with an accountant who can help explain to them the advantages and disadvantages from a tax standpoint.
The primary tax question you will run into in this situation will be whether to elect for your LLC to be treated as an "S Corp" for tax purposes. One of the first red flags you may run into when doing research on this topic comes when you read a blog or hear a podcaster talk about an "S Corp" as a type of company. Usually, these folks don't really understand the issues and have assumed that it is a type of company because the word "Corp" is in the term. However, and it's very important that you understand this, an "S Corp" is a tax classification, not a type of company.
If you are setting up an LLC to purchase a rental property or to help you with your side hustle, the tax choice you will face will be between an S Corp election or being treated as a disregarded entity. In my experience, many of my clients will opt for an S Corp election (after speaking with an accountant). However, it's important that you also discuss the ramifications of not electing to be an S Corp, in which case you would be treated as a disregarded entity for tax purposes, which is what we'll examine further here.
What is a Disregarded Entity?
A disregarded entity is a type of business entity that is "disregarded" by the IRS for federal income tax purposes, meaning that the business itself does not pay taxes on its income, but rather you (the owner) pays taxes on the business's income as part of your personal tax return. This is a popular choice for single-owner businesses, such as sole proprietorships and single-member LLCs, as it simplifies the tax process.
For a single-member LLC that is a disregarded entity and has no employees or excise tax liability, it does not need to obtain an Employer Identification Number (EIN). Instead, the owner can use their own name and Taxpayer Identification Number (TIN) for federal tax purposes. However, if the single-member LLC has taxable income and loss that will be reported by the owner, it will need to obtain an EIN, so I often recommend that my clients obtain an EIN when they set up their business.
It is important to note that although a disregarded entity is not considered a separate entity for tax purposes, it still maintains limited liability protection for the owner, meaning that the owner's personal assets are generally protected from business liabilities. However, it is still recommended to keep personal and business finances separate to further protect personal assets.
Filing Taxes for a Disregarded Entity
Even if you enjoy (or at least tolerate) doing your personal taxes, it's a different proposition when you are doing tax returns for your business and I encourage you to speak with an accountant before you attempt to do them yourself. While it may cost a little money, the time it saves you to work on your business instead of worrying about taxes usually works out to be a net positive for you and your business.
If you choose to try to do it yourself, when it comes to filing taxes for a disregarded entity, the owner would file a Schedule C with their personal tax return for sole proprietorships, or include the business's income and expenses on their personal tax return for single-member LLCs. It is important to keep accurate and organized financial records to ensure proper reporting and compliance with tax laws.
Before you automatically choose an S Corp election, you should make sure to talk to a professional and understand the impact of your decision on your business. And also, you can revoke your S Corp election in the future by following the process laid out by the IRS, so this isn't a lifetime choice that you and your business are stuck with.
Do I Need a Business Attorney?
If you or your business needs help with setting up an LLC, it's important that you talk to a business attorney. Let's schedule a Legal Strategy Session online or by calling my Edina, Minnesota office at (612) 294-6982 or my New York City office at (646) 847-3560. My office will be happy to find a convenient time for us to have a phone call to review the best options and next steps for you and your business, and if you need a connection to an accountant, I'm happy to connect you with some of the accountants that I work with who can help you with the proper tax classification for your business.