Lately I find people who are interested in entrepreneurship peppering me with questions about how they can get started, what kind of fees to charge and whether or not they need to form an LLC, otherwise known as a limited liability corporation.

This year I made enough dough to feel the pain at tax time, so creating an LLC is definitely on my mind—it can offer some benefits when the taxman comes calling. But I don’t know much about LLCs, what they mean or how to create one, so I reached out to another self-employed professional woman from my social network, Mayzie Brown. Brown is a Certified Public Accountant and spent seven years as an auditor for the Internal Revenue Service. These days, she’s running her own business in Colorado, helping people (like me!) with their accounting needs. Here’s what she had to say about when, how and why to form an LLC when you work for yourself.

What is an LLC, anyways? And how much do they cost?

An LLC is a company that provides limited liability to its owners throughout most of the country. Though this type of company does enable it’s owners to enjoy limited liability like owners of a corporation would, it is not a corporation. Additionally, this type of company has the option to pass through profits to the owners to be taxed at the lower individual rate. LLCs can have as few as one owner – there is no limit on the number of owners. LLCs can file taxes as a Sole-Proprietor (also known as a single-member LLC), an S-Corporation, or a Partnership

The cost of creating an LLC depends on what state you wish to create it in. In my home state of Colorado, someone doing all of the paperwork themselves will pay $50. I charge $250 – $50 for the filing fee and $200 to complete the paperwork (this includes the application to the state and the IRS for tax ID numbers).

Why would someone who is self-employed create an LLC?

There are normally three reasons for self-employed person to create an LLC:

The limited liability coverage: This means, that as long as personal and business funds are not co-mingled, only the assets and equity in the company are at stake, not your personal assets. By not creating an LLC, if you were to make a mistake and have a judgment charged against you, all personal assets are at risk of being taken away.

The option to be taxed as a Flow-Through entity (ie – an S-Corporation or a Partnership): By choosing to be a Flow-Through entity, as opposed to a Corporation (also referred to as a C-Corporation), you only get taxed once on your income. This is sometimes a hard concept to understand, but as a C-Corporation, any profit remaining after deductible expenses is taxed at the Corporate rate, which is 35%. Then, any disbursements from that profit to the owners of the company are considered dividends. The normal dividend rate is 15%. Therefore, you are essentially paying 50% tax on all profits withdrawn from the company

As a Flow-Through entity, any profit remaining after deductible expenses is taxed at the individual income tax rate (this can vary depending on whatever other income you may have, but it’s almost always less than the corporation rate, and is definitely less than the combined 50% rate after withdrawing dividends from a C-Corporation). Since you, as an individual, have already been taxed on the income of the corporation, any profits withdrawn are done so tax-free.

The ability to take a pay check and have taxes withheld throughout the year:  A lot of the time the biggest problem self-employed people come across is their tax bill. The reason for this is the fact that these individuals are subject to Self-Employment Tax, in addition to the regular income tax, on their business profits. By choosing an LLC, these individuals now have the option to form one of the Flow-Through entities discussed above. When this happens, the self-employed individual then becomes an employee of the entity and can take a pay check, having taxes withheld from the check.

This makes tax time a lot easier because you’ve already been paying a good chunk of your bill throughout the year. Also, the pay check a self-employed individual takes from the LLC is a deductible expense – thereby reducing your flow-through profit, which reduces the income taxes owed on that amount. Additionally, if you’re able to live off of less than what your self-employment income is (prior to forming an LLC that’s taxed as a Flow-Through entity), then you can reduce the amount you decide to take as a pay check. This will leave you with a higher flow-through profit. However, you are now able to take lump-sum distributions from the LLCs profits – avoiding the amount you would normally have paid in Self-Employment tax.

Is there an income “threshold” where an LLC starts to make sense?

There are no income thresholds for forming an LLC. If you’re concerned about the possibility of losing personal assets because of an error made professionally, it is in your best interest to create an LLC.

Does having an LLC change the way my clients pay me, and how I distribute income to myself?

Yes – to both questions. Your clients would now need to pay your LLC (and the EIN associated with that). So, payments would no longer go to Amy Hatch, they’d now go to Amy Hatch’s LLC Name and would be deposited into the business bank account set up for the LLC. As mentioned above, you would need to have the LLC give you a pay check, so that would definitely change how you distribute income to yourself.

What happens if I moved to a new state? Do I need to create a new LLC?

Not necessarily. Each state has different rules pertaining to LLCs – check with state to determine if a new LLC is required. In regards to your Federal Return – it doesn’t matter where the LLC was created compared to where you live now.

Bottom line: Is an LLC a smart business decision?

Personally, I see no reason why you wouldn’t create an LLC – it doesn’t cost much to do and it provides an extra layer of protection. Additionally, you have many more options on how you’d like to be taxed.

Photo:  reynermedia, Flickr