There are 3 main advantages for converting your proprietorship into a Limited Liability Company (LLC). The main advantage of operating as a limited liability company is that there is limited liability for the sole proprietor which means the owner’s personal assets are not exposed to the risks and liabilities of their business operations. The concept of the LLC statute is that the owner (technically referred to as a “member”) does not have any personal liability for business debts solely by reason of being a member. This liability protection could be particularly advantageous if you have employees working in the business, as their actions could potentially expose the owner’s personal assets. Of course, this does not relieve the owner of responsibility for personal actions nor for any debts personally guaranteed.
The second advantage of forming an LLC is the flexibility of choosing to be taxed as either a partnership, S-Corporation or as a sole proprietor, despite forming a separate LLC entity under state law. This becomes important because you can start off electing to be taxed as a sole proprietor, and as your business grows and when your annual net income exceeds $20,000 you can elect your LLC to be taxed as an S-Corporation. You can pay yourself a reasonable salary and then set up and contribute up to $15,500 to a Simple IRA, as well as up to $6,500 to a Roth IRA to maximize your retirement savings.
The third advantage is minimizing your taxes, because you do not pay the 15.3% social security tax on your S corporation net income just on the wages you pay yourself. In addition by contributing to a Simple IRA you reduce your federal income tax on the amount you contribute.
For example, in 2015, a 51 year old owner forms a single member LLC that makes an election and grosses $125,000 and nets $45,000 after expenses and after his LLC pays him $30,000 in wages. Assume the member makes the maximum $15,500 employee contribution to a Simple IRA. He would pay regular income tax at 20% on the $45,000 net income from the LLC. He would also pay self-employment tax and income tax on the $30,000 in wages.
|LLC Taxed as an||S-CORP||Sole Proprietorship|
|Less Operating Expenses||50,000||50,000|
|Self-Employment (FICA) tax||—-||6,100|
|FICA Tax on W-2 wages||4,600||—–|
|Income tax on wages||6,000||—–|
|Total Income tax||19,600||24,600|
In the above example, the member saved $5,000 in FICA tax by making an S election and contributing $15,500 into a Simple IRA. If the member contributes the maximum employee contribution to his Simple IRA of $15,500, then the Member will save an additional $3,100 in federal income tax on top of the $5,000 in savings in FICA tax savings indicated above. The member could also contribute $6,500 to a ROTH IRA but would receive no current year tax dedduction.
It is important to keep in mind that once the owner begins conducting business as an LLC, it will be necessary to consistently use the LLC designation on the business letterhead, the business checking account, business licenses, and the like. The owner would need to go through the process of adding the LLC designation to the various contracts, leases and documents under which business is conducted. The owner should never pay personal expenses out of the LLC bank accounts and should ensure the LLC has proper liability insurance. If you have any questions about forming an LLC, please contact Gregory J. Spadea at 610-521-0604 from the Law Offices of Spadea & Associates, LLC.