Entity Selection Part 1: Overview and Limited Liability Companies

What better way to kick off our Tax Talk Tuesday Series than by delving into a series focused on the intricacies of selecting the right business structure? Choosing the appropriate entity for your business is a pivotal decision that shouldn't be influenced by a social media post promising extravagant deductions and self-sustaining luxury vehicle expenses through the creation of an LLC. If only it were that simple. In the coming posts, we'll also explore the concept of ordinary and necessary business expenses to keep you on the right side of tax law, but for now, let's focus on the core topic at hand.

Your business is a culmination of your dedication and hard work, and the structure you choose is critically important. This decision involves a myriad of factors, encompassing tax implications, liability safeguards, administrative and tax filing obligations, and long-term considerations like capital infusion and exit strategies. While contemplating exit strategies might seem premature at the entity creation stage, it's essential to recognize that the choices you make today could potentially lead to substantial tax implications down the road. Hence, getting it right from the outset is imperative.

As you might expect, there's no one-size-fits-all solution when it comes to entity selection. The process is highly dependent upon the unique circumstances of your situation and should be made in conjunction with your professional advises. However, we will provide you with an overview of key differentiating factors and points to contemplate, empowering you to make a well-informed decision.

In this multi-part series, we'll begin by demystifying one of the most commonly misunderstood entity types - the Limited Liability Company, or LLC. While often the optimal choice for numerous businesses, the advantages of an LLC are not tax related. Let's clarify this point upfront: an LLC does not provide any additional tax deductions compared to operating as a sole proprietor. Should you be conducting a trade or business, the IRS treats earnings under an LLC the same as those earned individually, and they are even reported in the same section of your personal tax return. If you are thinking of creating an LLC with the expectation of deducting otherwise personal expenses, then you may have been misled and will unfortunately just be wasting money on professional fees and creating red flags on your tax return.

With this clarification in place, let's explore the genuine merits that make an LLC a compelling option for many entrepreneurs. Factors such as personal liability protection, anonymity, simplicity, and cost-effectiveness of formation all contribute to the allure of an LLC. From a tax perspective, LLCs are unmatched in their flexibility, and this is a crucial concept to comprehend - LLCs are merely a legal structure that has the option to be taxed in a variety of ways. Despite what you may have heard, there is no option to be “taxed as an LLC.” Rather, the tax law prescribes the following options for an LLC:

• If the LLC has only one owner, it defaults to being taxed as a sole proprietorship or you can elect to be taxed as a C-corporation, or an S-corporation. You often encounter the debate of LLC vs S-corporation, yet a business can legally be an LLC taxed as an S-Corporation. The debate should be focused on the tax implications of a sole proprietorship vs. one of the types of corporations, which we will cover in an upcoming post.
• If the LLC has more than own owner, it defaults to being taxed as a partnership, or you can elect to have the entity be taxed as a Corporation, or an S-corporation.

The choice to structure your business as an LLC predominantly constitutes a business and legal determination, one that provides tax flexibility. Other alternatives include operating as a sole proprietor, incorporating, or forming a partnership, which are generally less adaptable from a tax perspective. A widely applicable use of an LLC is to hold real estate assets. Consider a scenario where you intend to purchase a building for a coffee shop venture. By utilizing an LLC, you can maintain a clear distinction between the legal ownership of the building and the entity that operates the coffee shop. This demarcation mitigates operational risks associated with the coffee shop from impacting your ownership of the real estate assets.

In the forthcoming segments of this series, we will delve into the tax distinctions between a sole proprietorship, partnership, C-corporation, and S-corporation. These differentiations are critical to making the right decision for your business holistically, but with tax in mind.

If you're a business owner in the New York Metro Area and need help making the best decisions for your business, request a consultation with our experienced business consultants today. We look forward to providing you service.