Perhaps the most common question we get by clients starting a business or even just a side hustle is “Do I need an LLC?” My general response is that from a tax perspective it simply doesn’t matter most of the time.
What is an LLC?
A Limited Liability Company (LLC) is simply a legal business entity structure. The specifics of the administration and organization of LLCs is determined by each state. Every state has their own requirements, filings and fees associated with establishing and maintaining the LLC.
But what is germane to this article is that this has absolutely nothing to do with taxes. This is a LEGAL decision not an accounting or tax decision. Nothing changes by virtue of establishing an LLC. The same income is taxable whether an LLC is formed or not. The same deductions are eligible to be deducted whether an LLC is formed or not.
The biggest reason one might want to form a business as an LLC is for legal reasons (generally liability protection). The fact that your business operates as an LLC doesn’t suddenly allow that business to deduct something that otherwise wouldn’t be deductible.
Single Member LLC
The most common type of LLC we see is a Single Member LLC (SMLLC). For tax purposes, this is called a Disregarded Entity. That means that in the eyes of the IRS it’s as if the entity doesn’t even exist. We treat that entity the same way we treat an unorganized solo business and file the income and expenses on a Schedule C the same way.
Multi Member LLC
If more than one party is involved in an LLC that is termed a Multi Member LLC (MMLLC). Now, in this case, the default is to treat that as a partnership for tax purposes. The entity will file a partnership tax return each year and the various members (partners) will receive a k-1 that shows their proportional share of the income or loss of the LLC.
Which State Should I Form the LLC?
There is a ton of disinformation about this. Some people will pitch the value of a Nevada or Wyoming LLC. And while there may be some legal reason to consider those states or others, in the VAST MAJORITY of cases the LLC should be formed in the state the member(s) lives.
If you are a Maryland resident and determine that an LLC makes sense for your business you should register the LLC in Maryland in most cases. The reason is that the state the LLC is registered has no bearing on where the income is taxed. A UT LLC that operates solely in MD with MD members will require tax be paid in MD (as an example).
Fees and Annual Costs
Another reason I often dissuade clients from jumping head first into LLC formation is that there are costs associated with those entities. Each state has their own annual fee just to maintain the LLC ranging from fairly immaterial to significant (CA is $800 every year). In addition, there are forms and paperwork to be submitted. This increases our professional fees to you.
LLCs are an important tool in entity formation. They are relatively easy to setup and do provide some legal liability protection. But LLCs are overused and provide ZERO tax benefit.
My preferred approach with LLCs is to wait and see. Wait and see if the business or side gig sticks. Wait and see how material the income generated by the business really is. And when in doubt, consult an attorney who can advise on the necessity of forming an LLC.