“Do I need an LLC?” gets two bad answers. One is “yes, everyone needs one,” usually from someone selling formation packages. The other is “no, it does nothing.” The truthful answer is narrower. An LLC does one job well, it does not do several jobs people expect of it, and by itself it changes nothing about your federal tax. Here is what each structure does for a small trade business, with the rule behind each point.
The three choices side by side
| Structure | Business debts | Federal tax by default |
|---|---|---|
| Sole proprietorship | Yours personally: the SBA says the business’s assets and liabilities “are not separate from your personal assets and liabilities” | Schedule C on your own return, plus self-employment tax |
| LLC, one owner | The company’s, “in most instances” (SBA) | Disregarded: Schedule C and self-employment tax, as for a sole proprietor (IRS) |
| LLC, two or more owners | The company’s, “in most instances” (SBA) | Partnership, Form 1065 (IRS) |
| Corporation | The company’s (SBA) | C corporation: corporate tax, and possibly a second tax on dividends; S corporation by election: passed through to the owners |
What an LLC protects
The Small Business Administration puts it plainly: “LLCs protect you from personal liability in most instances, your personal assets — like your vehicle, house, and savings accounts — won’t be at risk in case your LLC faces bankruptcy or lawsuits.” Say a deck builder’s LLC runs up a supplier account it cannot pay and the business closes. The supplier’s claim is against the LLC and what the LLC owns, not the builder’s house, unless he signed for the account personally. That last condition matters more than most owners think.
What an LLC does not protect
Your own mistakes on the job
Maryland’s LLC law says a member is not personally liable for the company’s obligations “solely by reason of being a member.” In Allen v. Dackman (2010), the state’s highest court read that phrase and held that “a member of an LLC may be held liable for torts that he or she personally commits, inspires, or participates in, even though performed in the name of the LLC.” The member is liable, the court explained, “because he or she personally committed a wrong, not ‘solely’ because he or she is a member of the LLC.” That was one state’s court, and the rules differ by state. The point for a small trade business is plain all the same. When the owner is the one on the ladder, the person who might drop a tool through a skylight is the owner, and the LLC is not what pays for that. Liability insurance is, which is why the insurance you carry matters more than the letters after your name.
Debts you guarantee
Lenders know about the LLC shield, so they ask you to sign as well. For its 7(a) and 504 loans, the SBA’s page on its guarantee form (Form 148) says “Individuals who own 20% or more of a small business applicant must provide an unlimited personal guaranty.” Read every credit application, lease and loan before you sign it. Any debt you guarantee is your debt, LLC or not.
Payroll taxes you withhold
Once you have employees, the income tax and the employee’s share of Social Security and Medicare you withhold are what the IRS calls trust fund taxes, because “you actually hold the employee’s money in trust.” If they are not paid over, the IRS can assess the Trust Fund Recovery Penalty against a responsible person, a list that includes a corporation’s officers and employees, a partnership’s members and anyone with authority to direct the money. The penalty “is equal to the unpaid balance of the trust fund tax.” It applies where the failure was willful, and it lands on a person, not on the company.
A company that is not kept separate
Courts can set aside a corporation’s shield in some cases, which lawyers call piercing the veil. The Allen opinion quoted a federal court’s observation that “most commentators assume that the doctrine applies to limited liability companies.” The habits that keep a company separate are simple: its own bank account, its own card and its own books. See Separate Business and Personal Money: Account, Card and Books.
What an LLC does to your taxes: nothing, until you choose
The IRS says an LLC with one member “is treated as an entity disregarded as separate from its owner” for income tax unless it elects otherwise, and that its owner pays self-employment tax “in the same manner as a sole proprietorship.” An LLC with two or more members is a partnership by default and files Form 1065. Either kind can file Form 8832 to be taxed as a corporation, and one that qualifies can elect S corporation status. Whether that election pays is its own question, worked through in Should Your LLC Elect S Corporation Status?
One tax difference does come with the LLC. For employment taxes, the IRS treats even a one-owner LLC as a separate entity that reports wages under its own name and employer identification number. An LLC with employees needs an EIN of its own.
What an LLC costs: that is up to your state
The IRS calls an LLC “an entity created by state statute,” so the cost of having one is set by your state, and the range is wide. Two examples:
Your state’s business filing office lists its formation fee and any annual report. Your state revenue department lists any entity tax. Add them up for a year before you decide.
Check your license board before you switch
Changing the entity can change what your license board asks of you. California’s Contractors State License Board is a clear example. An LLC license needs a $100,000 LLC Employee/Worker Bond on top of the $25,000 contractor bond, plus liability insurance of at least $1 million when five or fewer people are listed on the license. The board says sole owner and corporate license numbers “may be reissued to LLCs under certain circumstances.” Other states have their own entity rules. Read your board’s page on business entities before you file anything with the state. The method is in Do I Need a Contractor License?, and California’s system is in Contractor Licensing in California.
And the corporation?
The SBA describes a C corporation as a legal entity separate from its owners that can be taxed and held liable on its own, with “more extensive record-keeping, operational processes, and reporting” than the other structures. Its profits can be taxed twice, once when the company earns them and again when dividends are paid. A business that wants its profit taxed once, on the owners’ own returns, can get that with an S election. The IRS allows it for a qualifying corporation and for a qualifying LLC alike.
Deciding, in five steps
- List what could actually go wrong: an injury or damaged property on a job, an unpaid supplier, a failed business. Insurance answers the first. An LLC answers the second and third, but only for debts you have not guaranteed.
- Price your state: the formation fee, the annual report or tax, any publication rule.
- Read your license board’s rules for entities: bonds, insurance, and whether your number can move over.
- If you form one, run it as a separate company from the first day: its own account, card, books and EIN.
- Leave the tax election for later. Test it each year once profit is well above a fair salary for your own work.
General information, not legal or tax advice. Rules change and vary by state; check with the agency named above or a professional for your situation.