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The key reason to form an LLC (limited liability company) is to shield the personal assets of the owners from that of the business. This means that if your company has bad debts or is sued, banks and other lenders cannot seize your personal property. But let’s face it. For many small business owners, questions about forming an LLC typically boil down to a single topic … taxes.

Whether it’s driven by a desire to escape self-employment taxes or looking to avoid that “double taxation” whammy, small business owners ponder which legal structure is right for their business and financial situation.

The LLC is often associated with “pass-through taxation,” meaning the LLC itself does not pay taxes. Rather, income from the business is passed to the company’s owners (aka members) who then claim these profits on their personal tax forms.

However, the LLC actually offers flexibility when it comes to federal tax treatment. This is because the LLC is an entity created by state statute. The IRS allows the LLC to be taxed as a corporation, partnership or sole proprietor, depending on elections made by the LLC and the number of members.

Under federal law, an LLC is classified as one of these types of taxable entities:

Single-member LLC as a “disregarded entity”

In this case, you’re the sole owner of the LLC and you report business income on your Schedule C tax form, as well as pay self-employment tax on the profit on the Schedule SE form. This is what’s typically called pass-through taxation, as the LLC does not need to file any tax forms. You will only need to pay self-employment taxes if you are engaged in an active trade or business; for example, if you provide a service to clients or sell a product. If you formed an LLC for a passive activity, like real estate investments, you will not have to pay self-employment tax on the profits (and in that case, you’d report your passive profits on Schedule E).

For example, Anne is a wedding photographer and formed an LLC for her business. The LLC earned $42,000 in profit this year. She will pay taxes on this $42,000 at her individual tax rate, as well as pay self-employment taxes (currently 13.3 percent for the calendar year 2011 for the first $106,800).

Multiple-member LLC as a partnership

With this arrangement, there are multiple members who own the LLC as partners. Unlike the single-member LLC described above, in this case, the multiple-member LLC reports its business income on a separate 1065 partnership tax return. Then, each partner pays self-employment taxes on their share of the partnership profit on the Schedule SE tax form. As with the single-member LLC, self-employment taxes only need to be paid if the LLC engages in an active trade or business.

LLC as a C corporation

An LLC can elect to be treated as a corporation for tax purposes by filing Form 8832 with the IRS. In this case, the LLC files a corporate tax return 1120. And the LLC profits are not subject to self-employment taxes. However, if the LLC profits are distributed to LLC owners in the form of dividends, those dividends are taxed again at the 15 percent qualifying dividend rate. The LLC treated as a C corporation is also responsible for payroll taxes on any wages paid to LLC members who work in the business.

For example, Paul owns a consulting company which earned $80,000 in profit. As a C corporation, the business would pay $27,200 in taxes on this income (assuming a 34 perent tax rate). If Paul then takes home that profit as a dividend, he would also owe taxes (at the 15 percent qualifying dividend rate) on the dividend payment.

LLC as an S corporation

In this case, the LLC elects to be treated as an S corporation. The S corp files an 1120S tax return, but the company’s profits are not subject to corporate income tax (like they are in the C corporation). Instead, individual LLC owners are taxed on their respective shares of the company’s profits (and profits are not subject to self-employment tax). If an LLC owner works in the business, they must be paid a reasonable wage for their activities and the LLC must pay payroll taxes on these wages.

Let’s say three sisters started an organic ice cream business and each own one-third of the business. They form an LLC and elect to be taxed as an S corporation. In the first year, their business earns $90,000 in profit. The ice cream business does not pay income tax on the profit. Instead, each sister includes her share of the profit ($30,000) in her taxable income on her individual tax return. And if their business lost $45,000 in the first year, each sister would include a $15,000 loss in her individual taxable income.

Choosing the right tax entity for your LLC is a weighty issue and will ultimately depend on all the unique aspects of your particular business needs, vision and circumstances. Investigate your options and stay on top of changing tax developments on both the federal and state levels that could affect your taxes.

Most importantly, know that the LLC is great for small business owners who want liability protection, but would prefer minimal formality (and paperwork). It’s also a perfect structure for a business with foreign owners, as anyone (C corp, S corp, another LLC, trust or estate) can be an owner of an LLC. So take some time and educate yourself on the benefits of forming an LLC and what tax treatment is best for you. After all, both you and your business are worth it.

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