I spend a lot of time online answering questions from new business owners, and there’s a certain question I find myself answering a lot.
“What do I register an online business under? LLC? Sole proprietorship?”
“Some questions about how to file? LLC or Sole Proprietor?”
There’s a lot of confusion over how to set up your business when you first get started. You want to do things simply, without setting yourself up for confusion or higher taxes later. You may have read that an LLC is the best way to get started quickly and easily, but what happens after you set that up? And will that change your tax status?
There are two statuses that matter: your status with the state you live in, and your status with the IRS. It’s a bit complicated but it means that you aren’t locked into doing one thing for both, and can pick and choose what you want to do, particularly with how you want to file. The LLC is a very flexible setup and you can elect to be taxed all sorts of ways, without changing anything about how you’ve filed with the state.
Filing Status with your State
If you do nothing:
State – will consider you as doing business under your own name. You can file a DBA (doing business as) application for your business name, if you want to be able to accept checks under your business name. A DBA will also protect your business name and no one else will be able to start a business with that name. However, if you are sued, you and your business are legally indistinguishable, and your personal assets may be at risk.
IRS – will consider you a sole proprietor and you will fill out a Schedule C with your taxes.
If you file a single-member LLC with your state:
State – now considers your business legally separate from you, so if you are sued, your personal assets will (in most cases) not be at risk. You can also accept checks under the business name and set up a business bank account in your business name.
IRS – will still consider you a sole proprietor and you’ll file a Schedule C.
If you file a multi-member LLC with your state:
State – same as above, though one of you will need to be designated as the “registered agent”, i.e. who gets the official mail.
IRS – will consider you a partnership and you will need to file a Form 1065, which shows the business’s overall profit and loss, and each member will get a Form K-1 which shows their portion of the overall profit and loss which they will then file with their taxes.
These options assume you’ve only filed paperwork with the state, and not with the IRS. If you like the default option, you don’t have to file anything with the IRS. However, you can file an IRS form to open up a couple more options for your tax filing status, and a good accountant can tell you if those would be a good move for you.
Filing Status with the IRS
If you do nothing, as a single-member LLC:
You’re still a sole proprietor and will file Schedule C. All income and expenses are contained there and you’ll personally pay the taxes on the business profit. This is pretty simple and you can probably do your taxes
If you do nothing, as a multi-member LLC:
You’re a partnership and will split the income and expenses between the partners. Each partner will then personally pay the taxes on their portion of the business profit. Assuming your LLC operating agreement allows for it, you can split up the income and expenses however you want – so one person could get taxed on most of the income (say, if one person has very little income other than the business and thus their marginal tax rate would be very low.) This would be the point you want to call in an accountant, though.
If you file IRS Form 8832:
You can choose to file taxes as if you are a corporation, without actually changing your status with your state. When you file this form, your LLC remains an LLC with the state, but the IRS will tax you as if you are a corporation, and you can choose whether you want to be taxed like an S-Corp or a C-Corp. An LLC taxed as an S-Corp is advantageous for many situations, but there are very few situations for a small business where C-Corp would be better.
What does it mean to be an LLC which is taxed like an S-Corp?
Being taxed as an S-Corp means that you’ll split your earnings into wages and dividends. You’ll pay yourself for the time you put into the business, roughly commensurate with what you’d pay someone else to do the same job. You’re then taxed on those wages just like you would if you were working a regular job. (A nice bonus here is that you get to skip self-employment taxes, about 7% of the wages.) Whatever’s left over becomes dividends, which are taxed at the much-lower capital gains tax rate. So this can be a good way to save money, IF your profit is larger than your reasonable wages for the time you put in. If you don’t end up paying out any dividends, you haven’t really lost anything, and you can change your wages/dividend allocation every year as things change in your business. Undoing this election is quite a pain though. Here is a longer description of what happens with S-Corp taxation.
I hope this helps clear things up! For most very small businesses, filing as a single-member LLC and leaving your IRS status as the default is probably all you need to do. Your taxes will be simple enough to do on your own and you’ll have much better protection from being sued. If your business grows and you’re putting in a lot more time, you can always elect S-Corp status later. You can also talk to a local accountant – getting your taxes done professionally costs a lot less than you might think if you take care of your data entry yourself throughout the year.