What?! You mean all those tax TikTok influencers are wrong? Everything you read on the internet isn’t actually true? Yes, that’s exactly what I’m saying. For some reason, this gossip started spreading that if you start an LLC you can write off a bunch of deductions. I think it may have been begun as a tax strategy utilized by ghost preparers who were preparing tax returns and including a business return with a huge loss to get their clients a huge refund, you know, just your basic tax fraud. Since then, this rumor has spread over the internet like wildfire, and it has confounded tax preparers for years. Let me share with you why, not only is this practice not even remotely legal, but it can also cost you money.
For starters an LLC is a legal entity, not a tax election like an S-corporation election is. The LLC was created as dual-purpose entity that had the same tax effects as a pass-through entity such as a partnership or single member LLC, but the protection of a corporation. An LLC’s main purpose is to protect your personal assets if your business is sued. That’s the main benefit, and there isn’t an additional tax benefit built into that. In fact, most states charge an annual fee just for having an LLC registered in their state. This is a minimum fee that you must pay whether you make $1 Million or have a net loss. In some states, this fee is so high that it can be prohibitive to even organize an LLC, so be sure to do your research on the cost of setting up and LLC in your state. However, for legitimate business owners, the annual fee is usually worth the protection that the LLC provides.
Speaking of legitimate businesses, a common misconception is that forming an LLC will somehow legitimize your claim to a slew of business deductions, even if you don’t have a lot of business income, or zero business income. The proper deduction of business expenses is to capitalize any costs incurred prior to the opening of a business and then amortize those costs over several years once the business starts earning income to match those expenses. A simple example of this would be opening a bar. When you open a bar you have to buy equipment to make the drinks, glassware, décor, and all the liquor for the bar. You may be purchasing items for the bar for several months before you even open the doors, which means there is no income to match those deductions, the income comes later, and so the deductions should come later as well.
You also want to be cautious of showing a business loss for several years in a row. The IRS will usually only give you three years of losses before they deem your business a hobby and no longer allow you to deduct the business loss on your return. You can argue and get the hobby status removed, but it’s difficult and you will probably need to retain a lawyer to help argue your case. Furthermore, this will put you on the IRS’s radar and create unnecessary hurdles for any future business ventures.
Keep in mind that any deductions taken under an LLC are not a dollar-for-dollar deduction either. The tax benefit is based on your effective tax rate and if you make your income low enough, the benefit is eliminated. This can also affect how much you receive for the Earned Income Credit. The Earned Income Credit is calculated based on, as the name suggests, your earned income. If you negate your W-2 income by taking a large business loss, then you no longer qualify for the Earned Income Credit and you could actually get less of a refund, than you would if you did not include the LLC loss. This is something that people in lower tax brackets usually have to worry about, but I have come across this issue on a couple of returns.
Finally, a big consideration for whether you should set up an LLC is the new Beneficial Ownership Information requirement under the Corporate Transparency Act. Under this new law, businesses organized in their state will be required to report ownership to FinCEN. Failure to do so can result in a penalty of up to $500 a day. The report is not complicated to complete, but since it isn’t part of the tax code, CPAs are being advised not to assist in the filing of this report. That means it will fall on the taxpayer to remember to file this report and if you aren’t great at remembering to file things in a timely manner, an LLC could end up costing you quite a bit of money.
Hopefully, this dispels some of the rumors around the purpose of an LLC and the “tax benefits" they can provide. The truth is an LLC should only be formed if you have the intention of building a successful business and is the first step in becoming a business owner. In general, you don’t want the reason you do anything to be “to save taxes”, the IRS will disallow that action. It needs to have a business purpose in order to be honored by a taxing authority.
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