How Your LLC's Tax Entity Structure Can Affect Your Bottom Line

Deciding on the correct entity structure is a concept that many LLC's and small business owners often overlook in their attempt to reduce their tax bill, as opposed to more commonly used strategies like deducting business expenses and depreciating assets, but there are a few situations where filing as a different entity can reduce your tax liability significantly.

A popular trend for small businesses is to incorporate as a Limited Liability Corporation within their state of operation. A LLC shelters your personal assets from possible litigation against your company in most cases, but from a tax perspective, a limited liability corporation does very little, in fact, the IRS does not recognize an LLC as an entity for tax purposes.

Businesses that incorporate as an LLC will usually file their taxes as one of the following--a Partnership, S Corp, or Sole Proprietor. (Companies can also choose to file as a C corporation as well, but you will be subjected taxation at the corporate and personal levels.) There are some advantages and disadvantages associated with each of these different filing entities, and being informed about each of them can be a major asset for your business going forward.

Sole Proprietors are unincorporated businesses or LLC's with a single owner, they usually file their taxes using a schedule C on their personal 1040. Filing your taxes using a schedule C is by far the easiest and cheapest way, mainly because of the simplicity of the form in comparison to a corporate return. Profits earned from a sole proprietor business are included in your adjusted gross income, and are also subject to the 15.3% self employment tax.

Many businesses do not have just one single owner, and when this is the case, the IRS deems your business a general partnership if two or more persons join to carry on a trade or business, and each share in the profit and losses. (Incorporating as an LLC will not affect your partnership status; the LLC will make it less complicated to declare a different entity though, like an S Corp.)

A partnership itself does not actually owe income tax, but the profits determined by federal form 1065 flow through to each partner's personal income tax return via a K-1 form. Income from a partnership is subject to self employment tax of 15.3%, just as a sole proprietor is, in many cases, this is what makes an S Corp a better option for some small businesses.

As mentioned above, changing your entity structure from a partnership to an S Corp can actually lower your tax bill each year. This is possible because S corp profits are broken down in to two different buckets of income, officer's salary and distributive share; only an officer's salary is subject to the self employment tax. A word of caution though, you cannot set your salary at a ridiculously low level to avoid this tax, an officer's salary needs to conform to the fair market wage for that job in your specific area.

Let say for example that you set your salary around 50,000 dollars for the year, but your total income is 90,000, the profit above and beyond your salary (40,000 in this case), will be considered a distributive share, and consequently is not subject to the self employment tax. If your filed as a partnership, or a schedule C sole proprietor, all of the profits would be subject to a 15.3% tax.

An S corp files a 1120-S form at tax time along with their state's subchapter S corporation tax form. Profits from the business will flow through to your personal 1040, just as a partnership would, and will be taxed at your personal marginal tax rate. Small business owners will need to first form a corporation, like an LLC, and then file form 2553 with the IRS to declare subchapter S. You will also need to call your state's government to find out if they will require you to pay any additional fees.

Robert Waldeck is a Tax Accountant, and owner of Waldeck Tax. To find an affordable tax service, or if you have a bookkeeping need, visit his website or blog.