A question that is becoming more common is whether there is any tax benefit to forming a Limited Liability Company (LLC)? The short answer is no. The decision to form an LLC should be made because of the legal protections it provides. For individuals who run a business, they should understand the different business structures and how they impact their tax return and their legal exposure.
If you run a business by yourself, you are considered a sole proprietor. When you run your own business, your income and expenses are reported on your individual tax return on a Schedule C. You should keep good records of your income and categorized expenses.
A partnership is a business where multiple people work together to run the business. Please know that if you and your spouse are the only two to run the business, you may consider yourself a partnership but for tax purposes, you will be treated as a sole proprietor. If you run your business with any other person besides your spouse, you will need to prepare and file a partnership tax return. From the partnership tax return, everyone involved in the business will be issued a tax form called a K-1, that will allocate your portion of the partnership to your individual tax return. Individuals who incur their own personal expenses that are not reflected in the business should keep track of those expenses; they can be used on your individual tax return to lower your tax liability.
What About an LLC?
Either of the businesses above can be formed as an LLC but that does not impact your tax return. An LLC provides legal protection in the event of a lawsuit. If you run a business that does not fall under the protection of an LLC, an individual who files a lawsuit against you may go after your personal assets, including your home and your personal finances, such as investments and retirement funds. However, under an LLC, a lawsuit filed against you may only go after the assets contributed to your LLC.
For illustration, let’s use a rental property as an example. You have spent $200,000 on buying and fixing up a home that you have decided to rent out. Unfortunately, an accident occurs on the property and your tenants file a lawsuit against you. If you have set up an LLC, the tenants can only seek up to $200,000 in damages, the amount you have spent on the property. However, if you have not set up an LLC, the tenants may seek unlimited compensation.
Who Should Form an LLC?
Just because you run your own business, it does not mean you necessarily need to form an LLC. Each state has their own requirements for forming an LLC, but they are going to come with a financial cost. Depending on the complexity, you may need to hire a lawyer to assist with the legal process. If you are deciding whether to form an LLC, you will want to consider how likely it is an individual will suffer either a physical injury or substantial financial loss when dealing with your company. Individuals who run performance camps or rental properties should strongly consider forming an LLC.
Although AFP Consulting can provide further information related to the tax implications of running your own business, individuals who have concerns over the legal exposure of their business may want to consulate with a lawyer.