LLC vs. S-Corp

A reader asks: This is my first year having an LLC. I’m getting started on my tax return, but I’m confused about which forms I need to file. I see in some places that it says I need to file a 1065, and in other places it says I just put the income on my 1040 (using schedule c?). Which one of these is right?

Answer: That depends on how many members (ie, owners) there are for your LLC.

If you’re the only owner, your LLC is going to be taxed as a sole proprietorship. In that case, yes, you’d fill out Schedule C, and you would include the profit from the business on your Form 1040.

If, however, your LLC has multiple owners, it will be treated as a partnership for Federal income tax purposes. In other words, you’ll fill out Form 1065, and each of the partners will receive a Schedule K-1 indicating their share of the business profits. Then each partner reports those profits on their 1040, using Schedule E.

For More Information, See My Related Book:

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less See it on Amazon.

• The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
• How to protect your personal assets from lawsuits against your business,
• Which business structures could reduce your Federal income tax or Self-Employment tax,
• Click here to see the full list.

June 7, 2009 0 comments

Form W-9 is different from most other tax forms in that it is not sent to the IRS. The purpose of the form is simply to gather information from a business. (The business could be a sole proprietor/independent contractor, an LLC, a partnership, or a corporation.)

For example, Business A would send Form W-9 to Business B in order to request Business B’s legal name, address, and taxpayer ID (FEIN). Business B is then required to fill out the form and send it back to Business A. The information contained on the W-9 is then used by Business A to prepare the 1099 for Business B for the year. (Of course, if Business B is a corporation, no 1099 will be required.)

How to Fill Out Form W-9

Filling out a W-9 is pretty easy. On the first line, simply enter your legal name (if a sole proprietorship) or the legal name of your business (if an LLC, corporation, or partnership).

On the next line, enter your “Doing Business As” name, if applicable. (For instance, if you’re a sole proprietor doing business as “Jane’s Jewelry,” you would put your actual legal name on the first line and “Jane’s Jewelry” on the second line.)

In the next section, check the box that applies to your type of business (LLC, corporation, partnership, etc.). If your business is an LLC, you are then asked to indicate its tax treatment (ie, is your LLC taxed as a partnership, sole proprietorship, or corporation?).

What to put on the “Address” line should be pretty self-explanatory.

In the next section, if you’re a sole proprietor, enter your SSN in the appropriate box. If your business is anything other than a sole proprietorship, enter your Tax ID (a.k.a. FEIN) in the box labeled “Employer Identification Number.”

Now just sign and date the W-9, and you’re all finished.

For More Information, See My Related Book:

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less See it on Amazon.

• The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
• How to protect your personal assets from lawsuits against your business,
• Which business structures could reduce your Federal income tax or Self-Employment tax,
• Click here to see the full list.

June 7, 2009 0 comments

The primary downside to operating your business as a sole proprietorship requires little explanation. In essence, the problem is that a sole proprietor is personally liable for all of the debts of the business. This is known as having “unlimited liability.”

To elaborate, if anybody successfully sues your business, they’ll be able to come after your personal assets, not just the money that you have in your business checking account. To be perfectly clear, this means that—if the suit is for enough money—you could end up losing all of your personal savings, your car(s), your home, and anything else you have that might be of value. Everything.

Oh My Goodness That’s Scary! (Right?)

For many people, just reading a description of what exactly it means to have unlimited liability is enough to get them to start Googling “how to form a corporation.” And that’s understandable.

But before you go and spend a substantial amount of time and money forming some other type of business entity, spend a little time thinking about how big of a problem unlimited liability really is for your business.

For instance, do you offer a service, or do you create and sell a product? In either case, imagine the worst-case scenario, and think about how bad it really is.

Let’s say you provide a service. What’s the worst thing that could happen if everything goes wrong with a client? Does the client lose millions and millions of dollars? Does the client need a trip to the hospital? Or, perhaps, is the worst-case scenario simply that the client is out the money that you charged them?

If you create and/or sell a product, do the same type of analysis. If everything goes as terribly wrong as you could possibly imagine, what happens?

If the worst thing that you can think of isn’t really all that bad, then perhaps—despite nearly everything you read online—it isn’t necessary to incorporate or form an LLC.

EXAMPLE: A self-employed author who writes and self-publishes science fiction novels. (I don’t know about you, but I can’t think of too many things that could go wrong for this business owner that would result in significant liability to anybody.)

Simple Summary

• As a sole proprietor you will have “unlimited liability” for any debts of the business. This means that, in the case of a lawsuit, somebody could come after your personal assets, not just business assets.
• Depending upon the nature of your business, it’s at least possible that unlimited liability isn’t that big of a problem.

For More Information, See My Related Book:

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less See it on Amazon.

• The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
• How to protect your personal assets from lawsuits against your business,
• Which business structures could reduce your Federal income tax or Self-Employment tax,
• Click here to see the full list.

June 7, 2009 0 comments

If your business is organized as anything other than a sole proprietorship, you’re going to need to get a tax ID for your business. A tax ID (sometimes referred to as a Federal Employer Identification Number, or FEIN) is analogous to an SSN for an individual.

If your business is a sole proprietorship, an FEIN isn’t required. However, it’s probably a good idea to get an FEIN for your business anyway, otherwise you’re going to have to share your SSN with many of your vendors and customers.

The process for getting an FEIN is quite simple. You have two options:

1. Fill out and file Form SS-4.
2. Apply for an FEIN online at IRS.gov.

Assuming that you opt for the online application, the entire process takes only a few minutes. You’ll be asked a series of questions about your business, none of which are difficult to answer. (Questions like, “How many owners does your business have?” “What industry is your business in?”)

After completing the survey, you’ll receive a confirmation indicating your new Tax ID. Print out this confirmation, and save it with your other important business documents.

That’s it. Nothing much to it.

For More Information, See My Related Book:

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less See it on Amazon.

• The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
• How to protect your personal assets from lawsuits against your business,
• Which business structures could reduce your Federal income tax or Self-Employment tax,
• Click here to see the full list.

June 7, 2009 0 comments

To put it as concisely as possible, partnership taxation works very much like sole proprietorship taxation, but with an extra step in the middle in which the profit (or loss) gets allocated to the partners.

Partnerships themselves are not actually subject to Federal income tax. Instead, they—like sole proprietorships—are pass-through entities. While the partnership itself is not taxed on its income, each of the partners will be taxed upon her share of the income from the partnership.

Form 1065

Form 1065 is the form used to calculate a partnership’s profit or loss. Filling out a Form 1065 is no more difficult than filling out a Schedule C for a sole proprietorship. On the first page, you simply list the revenues for the business, list the expenses for the business, and then subtract the total expenses from the total revenues. It’s exactly what you would expect.

On the second page of Form 1065 you answer several yes/no questions about the nature of the partnership. For instance, you’ll be asked whether any of the partners are not U.S. residents, whether the partnership had control of any financial accounts located outside of the U.S., and other questions of a similar nature.

Schedule K and Schedule K-1

The third page of Form 1065 is what’s known as Schedule K. Schedule K is used to break down the partnership’s income into different categories. For instance, ordinary business income goes on line 1, rental income goes on line 2, interest income shows up a little bit later on line 5, etc.

After filling out Schedule K, you’ll fill out a separate Schedule K-1 for each partner. On each partner’s Schedule K-1 is listed that partner’s share of each of the different types of income.

EXAMPLE: Aaron and Jake own and operate a partnership. Their partnership agreement states that they’re each entitled to exactly 50% of the partnership’s income. If, on Schedule K, the partnership shows ordinary business income of $50,000 and interest income of $200, each partner’s Schedule K-1 will reflect $25,000 of ordinary business income and $100 of interest income. This income will eventually show up on each partner’s regular income tax return (Form 1040).

What’s important to note here is that allocations from a partnership maintain their classification once they show up on the partners’ individual tax returns. This is important because the tax rate on some types of income/gain is different than the rate on other types. For instance, long-term capital gains (gains from the sale of investments that were held for greater than one year) are taxed at a maximum tax rate of 15%.

EXAMPLE: Aaron and Jake’s partnership buys shares of a stock, holds the shares for several years, and then sells them for a gain of $10,000. When Aaron’s $5,000 share of the gain shows up on his tax return, it still counts as a Long-Term Capital Gain (as opposed to counting as ordinary income). As such, it will only be taxed at 15%, even if Aaron is in the 25% tax bracket.

Self-Employment Tax for Partnerships

Ordinary business income from a partnership is generally subject to the Self-Employment Tax when it is passed through to the partners. This makes sense given the rule that we just discussed about income maintaining its classification when allocated to a partner on his or her K-1.

Allocated Profit vs. Distributed Profit

One thing that many owners of partnerships are surprised by when their first tax season rolls around is that partners get taxed on their allocated share of the profit, regardless of what was distributed to them. Don’t worry. It sounds complicated, but it’s really not that bad. This is something best explained with an example.

EXAMPLE: Michelle, Kayla, and Tim start a partnership. Their partnership agreement states that profit or loss will be evenly allocated to the partners.
In the first year, their partnership makes $60,000. However, they’re sure that their business could grow quickly if they had the capital. So, they decide not to distribute any cash to the partners. Instead, they make plans to use all $60,000 to buy new production equipment next year.

Despite the fact that none of the partners actually received any cash payout, they’re each going to be taxed on $20,000 of business income (1/3 of the $60,000 total). That is, each is taxed on his or her “allocated profit” of $20,000 rather than his or her “distributed profit” of $0.

[Note: Profits and losses in a partnership are not required to be split evenly between the partners. The partners can choose to split the profit or loss in any way they choose. It just makes the math in the examples easier if we give each partner an equal share.]

In Summary

• Like sole proprietorships, partnerships are “pass through” entities. A partnership is not subject to Federal income tax. Rather, its owners are subject to Federal income tax on their share of the profit.
• Form 1065 is used to calculate a partnership’s profit or loss.
• Schedule K and Schedule K-1 are used to show each partner’s allocated share of the profit/loss.
• Income (or gain) from a partnership maintains its original classification when it is passed through to a partner. As such, long-term capital gains will be taxed at a max rate of 15%, and ordinary business income is subject to Self-Employment Tax.
• Partners are taxed on their allocated share of the profit, regardless of how much of the profit is actually paid out to them.

For More Information, See My Related Book:

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less See it on Amazon.

• The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
• How to protect your personal assets from lawsuits against your business,
• Which business structures could reduce your Federal income tax or Self-Employment tax,
• Click here to see the full list.

June 7, 2009 0 comments