This question is asked of me all the time and there is a large amount of misinformation out there on the internet written by folks that don’t fully understand the tax implications of these different entity types. The first thing I’d like you to understand is that every entity type has both a legal impact and a tax impact. For example, when you form a Limited Liability Company (LLC) it will forever, in the eyes of the law, be an LLC. However, that same LLC, from a tax perspective, can be treated as a sole-proprietor, partnership, S Corporation or C Corporation. Clear as mud? Stay with me, I’ll clarify by explaining each entity type.
What is a (P)LLC (from a Legal Perspective)?
LLC stands for Limited Liability Company, and as the name implies, an LLC is a business structure created by state law that provides limited liability protection from its owner(s), which are called members. An LLC may provide protection against the member’s personal assets. For example, if your LLC is sued (and you’ve maintained your LLC appropriately) your personal assets such as your home, automobiles, bank accounts may be protected. This layer of protection is often referred to as the “corporate veil”. Please note that because the LLC business structure is created by state law (as opposed to federal law), the protection afforded to the LLC will differ by state and consulting with a business attorney within your state is recommended.
PLLC stands for Professional Limited Liability Company. There are about 30 states that require you to form a PLLC (instead of an LLC) when you are a licensed professional (e.g. a Real Estate Agent, Attorney, CPA, etc.). The PLLC is akin to the Professional Association (P.A.). Non-licensed individuals form C Corporations and licensed individuals form P.A.s.
What is a (P)LLC (from a Tax Perspective)?
A (P)LLC, when utilizing the default tax treatment provided by the IRS, is either taxed as a sole proprietorship or partnership. Let me elaborate:
How is a Single-Member (P)LLC taxed?
A single-member (P)LLC is a (P)LLC in which there is only one member (owner). By default, a single-member (P)LLC is considered a “disregarded entity” for tax treatment purposes by the IRS. In other words, for tax purposes, the single-member (P)LLC is taxed in the same exact manner as a sole proprietor. A Sole Proprietorship reports all business income or losses on their personal tax return by completing Schedule C, Profit or Loss from a Business which will be submitted together with Form 1040, U.S. Individual Income Tax Return. In other words, a sole proprietor attaches an additional schedule to their personal tax return. (There is not a separate federal income tax return that needs to be filed with the IRS when your business is a single member (P)LLC).
How is a Multi-Member (P)LLC taxed?
Multi-member (P)LLCs: A multi-member (P)LLC is a (P)LLC in which there are two or more members (owners). By default, a multi-member (P)LLC is treated as a Partnership for federal income tax purposes. As a result, the multi-member (P)LLC will file Form 1065, U.S. Return of Partnership Income, a separate informational tax return. The (P)LLC members will then be issued a form called a K-1 to report each (P)LLC member’s share of the partnership’s earnings, losses, deductions and credits. The amounts on the K-1 will be used to prepare Form 1040, Individual Income Tax Return for each of the (P)LLC members. To summarize, unlike single member (P)LLCs, there is a separate tax return that must be prepared and filed with the IRS for multi-member (P)LLCs. Also, if you are wondering what a K-1 is, think of it as a W-2 issued by an employer to report the employee’s income on their individual tax return. Lastly, it is very rare that I would ever recommend that an independent contractor, such as a real estate agent or Realtor, form a multi-member (P)LLC.
Am I stuck with the default treatment for my (P)LLC?
No, both a single-member and multi-member (P)LLC can elect to be treated as an S Corporation or C Corporation. In order to have the (P)LLC taxed as an S or C Corporation you will complete documentation and file it with the Internal Revenue Service (IRS), not with the State in which you formed your (P)LLC.
Why would I want my (P)LLC treated as an S or C Corporation.
The details of why you would want your (P)LLC treated as an S Corporation are beyond the scope of this post, however, the primary reason is to save money on self-employment taxes (Social Security and Medicare aka FICA). In general, electing to have your (P)LLC treated as an S Corporation will save you money (usually thousands of dollars) after you cross $40,000 in profit. I am defining profit as your commissions/revenue minus your expenses such as advertising and mileage. Until then, your single-member LLC is best left as being treated as a sole proprietorship for tax purposes. This is why the (P)LLC is so popular – it can be taxed as a sole proprietorship to start, and once you’ve crossed the $40,000 profit threshold, you can make the S Corporation election.
It is extremely rare that you would elect to have your (P)LLC treated as a C Corporation so I will not go into that here. Basically, if your (P)LLC was going to raise capital by becoming a publicly traded company, such as Amazon, you would make the C Corporation election.
What is a P.A. / Corporation (from a Legal Perspective)?
A Corporation is a business structure created by state law that provides limited liability protection from its owner(s), which are called shareholders. An Corporation may provide protection against the member’s personal assets. For example, if your Corporation is sued (and you’ve maintained your Corporation appropriately) your personal assets such as your home, automobiles, bank accounts may be protected. This layer of protection is often referred to as the “corporate veil”. Please note that because the Corporation business structure is created by state law (as opposed to federal law), the protection afforded to the Corporation will differ by state and consulting with a business attorney within your state is recommended.
P.A. stands for Professional Association. Almost all states require you to form a P.A. (instead of a Corporation) when you are a licensed professional (e.g. a Real Estate Agent, Attorney, CPA, etc.). The P.A. is akin to the PLLC. Non-licensed individuals form LLCs and licensed individuals form PLLCs.
What is a P.A. / Corporation (from a Tax Perspective)?
By default, both a P.A. and a Corporation are taxed as C Corporations. C Corporations are subject to double taxation which means that the Corporation itself will pay income taxes, and then the shareholders (owners of the corporation) will pay taxes on the profits distributed to them in the form of dividends. A C Corporation will file Form 1120, U.S. Corporation Income Tax Return.
Am I stuck with the default tax treatment of my P.A. / Corporation?
No, both P.A.s and Corporations can elect to be treated as an S Corporation or C Corporation. In order to have the P.A. or Corporation taxed as an S Corporation you will complete documentation and file it with the Internal Revenue Service (IRS), not with the State in which you formed your P.A. or Corporation.
Why would I want my P.A. or Corporation treated as an S Corporation.
The finer details of why you would want your P.A. or Corporation treated as an S Corporation are beyond the scope of this post, however, there are two primary reasons. The first reason is to avoid double taxation as noted above…nobody wants that. The second reason is to save money on self-employment taxes (Social Security and Medicare aka FICA). In general, electing to have your Corporation treated as an S Corporation will save you money (usually thousands of dollars) after you cross $40,000 in profit. I am defining profit as your commissions/revenue minus your expenses such as advertising and mileage.
So Which One Should I Form and When?
Each person’s situation is unique, but in general, if you are an independent contractor such as a Real Estate Agent, Realtor or Insurance Agent I would usually point you to a Professional Limited Liability Company if your state allows for it, if not, establish a Limited Liability Company. The (P)LLC provides the most flexibility from a tax perspective. Once you cross the profit threshold to execute the S Corporation tax strategy, you can make an S Corporation election. Contrary to what you may read or what is written on Form 2553, Election by a Small Business Corporation, you can make the S Corporation election at anytime (not just within the first 75 days of the (P)LLC being formed).
In regards to when you should form the (P)LLC, in my view, you should form one as soon as possible in the year in which you forecast you could cross $40,000 in profit. The reason is you need to have the (P)LLC established to make the S Corporation election. For example, let’s say you make $60,000 in commissions/revenue during a calendar year. If you created your (P)LLC in January of that calendar year, then all of your commissions will be subject to the S Corporation tax treatment. If you wait until October of that calendar year, then only your commissions from October through December are subject to being treated as an S Corporation. In other words, the P(LLC) is your ticket into the S Corporation tax savings club.
About the author: Navi Maraj is a Certified Public Accountant in the State of Florida and is the President of FileYourBusiness.com, Inc. and the owner of Navi Maraj CPA, PLLC. FileYourBusiness.com is a website dedicated to educating entrepreneurs about legal entity types and their respective tax treatment. Additionally, Florida entrepreneurs can utilize FileYourBusiness.com to form their business. Navi Maraj CPA, PLLC is an accounting and tax firm specializing in helping independent contractors and small business owners.
Disclaimer: The content of this article is not to be considered legal or tax advice and is provided for informational purposes only.