Last week, we explored the basics of the sole proprietorship. I had a sole proprietorship for my business, until I discovered some of the joys of the LLC. It is important to note, though, that a LLC is not for everyone. And you need to be aware of some of the limitations that come with a LLC before you decide to organize in this way. One of the reasons for forming a LLC is that you are protected from personal liability, like a corporation, but you are not double taxed the same way a corporation is.
The LLC is usually best for a small business with a limited number of owners who are not particularly interested in seeing significant business growth. As a freelance writer, the LLC has been rather ideal for me.
Setting Up the LLC
Normally, it is relatively easy to set up a LLC. While not as simple as setting up for a sole proprietorship, it is still usually easier than setting up for a corporation. You will need to file articles of organization, and your state may require an operating agreement. Depending on the state, you might be able to set it all up with one or two pieces of paper, using a form provided by the your secretary of state. A knowledgeable attorney or accountant can also often help you for the reasonable price of between $150 and $500 (although it might be more in some states).
You should also realize that in some states you are required to have at least two members to set up a LLC. In my case, I just use my husband as the other member. I’m the managing member, and he is the general member. You should think carefully about who fulfills which role as well, since that matters when it comes to taxation. Also, keep in mind that an LLC can be liable for negligence claims. For that reason, you’ll need business insurance, such as the small business insurance from Hiscox for instance.
It is possible for you to contribute or loan your assets to the LLC, and it is possible to set up retirement plans for employees and members. You are paid simply by writing yourself a check, called a distribution. Note, though, that the managing member cannot pay him or herself a salary, even though he or she can take distributions.
Another nice thing about the LLC is that it can be converted to a corporation. So, if you decide you want to grow your small business, and a LLC is no longer appropriate. It is then possible to transfer your LLC assets to a corporation.
Taxes and the LLC
A LLC is known as a pass through entity. This means that the LLC itself does not pay taxes. The earnings pass through to the members (owners) of the LLC. There is still special tax paperwork to be filled out, though, and a separate tax return is prepared for the LLC. If there is only one member (a rarity), though, the LLC will be taxed as a sole proprietorship.
When tax time comes, the managing member’s share of the bottom-line profit is viewed as earned income. This portion of the profit is subject to self-employment tax. However, the other members’ portion of the bottom-line profit is not considered earned income. Note that all members’ shares (including the managing member’s) of the profits are reported on their own 1040 forms as income, and taxed accordingly (even though it is not earned income for non-managing members).
It is also worth noting that the managing member of the LLC is allowed to deduct 100% of the health insurance premiums paid up to the pro-rata share he or she has of the LLC’s profit. My accountant figured out how much my husband and I should each get for distributions in order to allow me to take the deduction for the health insurance premiums while minimizing the self-employment tax paid.
For example, I, as managing member, receive 7% of the profits, while my husband, the non-managing member, receives 93%. His income from the LLC is not earned income, so we don’t pay self-employment tax on it. We only pay self-employment taxes on the 7% that makes up my share. We do pay regular income taxes on all of the profits, though. The main savings come from the reduction in self-employment taxes.
In the end, there are some advantages that can make a LLC desirable for a small business organization. Consult with a professional to see if this business organization might work for you.