You might have heard someone online say,

"Open an LLC and you'll save thousands in taxes."

What the statement doesn’t say is, the IRS generally doesn't tax an LLC. To be succinct, the IRS taxes the election the LLC makes or doesn't make. That's the fly in the ointment. Hopefully that makes sense.

A Limited Liability Company is first and foremost a legal entity created under state law. When it comes to federal tax purposes, the IRS allows that entity to be taxed in several different ways depending on its ownership and elections.

According to the IRS:

If an LLC doesn't automatically lower taxes, why do millions of Americans form one? Because taxes aren't the primary reason LLCs exist, that's why.

The principal benefit is found in the name itself:

Limited Liability Company.

Generally speaking, the LLC creates a legal separation between business activities and the owner's personal assets, but it depends. This separation can become extremely important if the business is sued, defaults on obligations, or encounters significant financial problems.

Always remember, liability protection is not absolute. Courts may disregard an LLC under certain circumstances, particularly where owners fail to observe legal formalities, commingle business and personal assets, or engage in fraudulent conduct.

Even so, liability protection, not tax savings, is usually the reason attorneys, which I’m not one by the way, recommend forming an LLC. Tax savings often come later, and only if there is justification for a different tax election.

Part of the confusion comes from, you guessed it, how the internet talks about LLCs.

If you search YouTube or the internet in general, for "LLC tax savings." You'll find countless videos with titles like:

Of course those headlines are trying to attract views and clicks. They rarely tell the complete story, and what frequently happens is this:

Someone forms an LLC. Later, after the business becomes profitable, the owner elects to have the LLC taxed as an S corporation, because that’s what the gurus are doing on the video.

The S corporation election, not the LLC itself, may produce tax savings under the right circumstances. These are two separate events. I’m talking about Schedules B-1, D, K-1,2,3, and M-3. Can I get an Amen! Sorry, schedules get me excited sometimes.

Unfortunately, these are often presented as though they're the same thing.

This is where the rubber meets the road. There are situations where an LLC can become part of an effective tax strategy. Notice I said part of the strategy. Not the whole strategy.

Suppose two contractors each earn $250,000 annually. The first operates as a sole proprietor. The second operates through an LLC that has properly elected to be taxed as an S corporation.

If the second contractor, the S Corp, pays himself a reasonable salary, as required by the IRS, and satisfies all other legal requirements, part of the remaining business income may avoid self-employment tax because it is distributed as S corporation income rather than wages. This distinction is one reason profitable businesses sometimes elect to be taxed as an S corporation. However, the owner must also consider additional payroll requirements, compliance costs, state taxes, and the obligation to pay reasonable compensation.

Sounds good! Why doesn’t everyone elect to be taxed as an S corporation?

Well, for some businesses, the additional payroll costs, accounting fees, and compliance requirements outweigh any tax benefit. Like many things in taxation, the answer depends on how much profit the business is making and the way business is conducted on a day to day basis.

Instead of asking,

"Should I form an LLC?"

a better question might be,

"How should my business be taxed, based on the amount of income and profit it earns?"

These are very different questions. The first question concerns the legal structure and protections an LLC offers to a business. The second question concerns your tax strategy which could lead to saving a bunch of money when it comes to paying taxes.

Understanding that distinction can prevent expensive tax and legal mistakes, and also may help business owners recognize opportunities they didn't know existed.

In Part Two, we'll try to answer the questions most business owners actually care about:

This article is provided for informational and entertainment purposes only. It is not tax, legal, investment or financial advice specific to any person, business or organization. Tax laws, program rules and individual circumstances may change. Consult qualified advisers before opening, funding or withdrawing money from any account discussed here.

The Smith Advisory LLC helps business owners, farmers and real estate investors understand how tax decisions, tax-ready books and long-term financial planning work together. To discuss how these rules may affect your family or business, contact The Smith Advisory LLC at [email protected].