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  • Michael Henninger

Entities Part 2: Limited Liability Companies (LLC)

Entities Part 2: LLC's

- What is a Limited Liability Company or LLC?

A limited liability company (LLC) is a business structure that is authorized by state statute (each state may have slight variations, so be sure to check with your state’s statute). From a 35,000-foot view, it’s a business structure that protects its owners from personal liability for the business debts and creditors. LLC’s are a hybrid entity that combines some of the characteristics of a corporation with those of a sole proprietorship or partnership.

As mentioned above, LLC’s are authorized under state statute and although the rules governing them vary from state to state, there are some commonalities that apply to all. For instance, LLC owners are generally called members. Anyone can be a member of an LLC including Individuals, corporations, foreigners, foreign entities, and even other LLCs. There are, however, some entities that cannot form LLCs, among them are banks and insurance companies

An LLC is treated as a sole proprietor (one member) or a partnership (multiple members) depending on the number of members. The LLC itself is considered a pass-through entity which means the income or loss “passes through” to the members. An LLC does not pay tax at the entity level, the income is reported on the individual income tax return of the member owner on Schedule C/E for a single member LLC. For LLC’s with multiple members, Form 1065 (Partnershi Return) is filed. The partnership itself does not pay tax, instead, it reports each member’s share of distributive income/loss on Schedule K-1 which the member then reports on their personal return (Schedule E).

Another key thing to note is that LLC members are not employees per se and don’t receive wages that withhold self-employment taxes (Social Security and Medicare). Instead, most LLC members are required to pay these taxes directly to the IRS. As an employee, a person pays 7.65% in SS and MC taxes and their employer must match that and send those taxes in on their behalf. That’s a total of 15.3% (7.65% from the employee and 7.65% from the employer). In most instances, members of an LLC must pay both sides of these taxes because, in essence, members of an LLC are both the employee and the employer.

Now, we say “in most instances” because owners who are not active in the LLC (i.e. those who have simply invested money but don't provide services or make management decisions) may be exempt from paying self-employment taxes on their share of profits, but that’s beyond the scope of this article. Suffice it to say, if you actively manage and/or work in your LLC, you can expect to pay self-employment tax on all LLC income allocated to you.

Overall, LLC’s are not vehicles used to lower taxes. They’re used more for their liability protections as opposed to the sole prop structure. To begin to utilize them as a tax saving strategy, an election is necessary, the S election….

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