Today’s blog will cover the crucial tax errors that LLCs and new business owners need to steer clear of. As LLCs are widely known for their flexibility, it is vital to comprehend the potential hazards that come with this entity structure. The LLC formation is a popular choice for businesses, but with it, business owners need to bear in mind the significant responsibilities that come with it. Understanding and avoiding common tax blunders are critical for business owners looking to establish an LLC, as mistakes in this area can have serious implications. Being aware of potential tax mistakes can help new business owners avoid costly and time-consuming penalties.
Make sure to avoid these top 10 common LLC mistakes small business owners typically commit to ensure success.
1. The Best Entity Structure for Your Business
One of the first things to consider when starting an LLC is if it is the best entity structure for your business operations. There are three types of operations: ordinary income, passive income, and portfolio income. The type of activity in your business will determine the type of operation you have and each type is taxed differently by the IRS. Therefore, it is important for business owners to understand which type of activity they fall into.
Ordinary income comes from services and products provided by the business owner actively working in their business. If the business owner is involved in daily operations, they are likely subject to ordinary income tax rates and self-employment taxes (15.3% Social Security and Medicare taxes).
Passive income, on the other hand, is earned through investments such as real estate or dividends. It is not subject to self-employment taxes as the business owner is not actively working in the business but simply collecting income from their investments. This type of income may be a good reason to set up an LLC, but it is always recommended to consult with a tax strategist or CPA to determine the best option.
Another type of business operation is Portfolio income. It is derived from capital assets and capital gains. This type of income is generated when buying or selling stocks or shares of the business.
It is essential to understand the type of operations in your business, and the tax implications that come with it. Making sure you have the proper entity structure and tax strategies in place will help you avoid costly tax mistakes.
2. Not Associating The EIN Number with Income and Expenses
As a business owner, it’s crucial to understand the different tax brackets associated with your income portfolio. One common tax mistake is not registering your Employer Identification Number (EIN) with the IRS and not linking it to your business bank account.
Your EIN, also known as your business’s Social Security number, helps you keep track of your business income and expenses and makes reporting much easier. It’s important to have a separate bank account for your business to differentiate personal and business expenses. Without an EIN, the IRS may have a hard time verifying your business activities.
To obtain an EIN, you’ll need to file Form SS-4 with the IRS. After registering with the state as an LLC, you’ll receive an EIN number that you’ll use to open a business bank account. If you own multiple businesses, be sure to have an EIN for each one to keep your income and expenses separated.
3. Did Not Set Up an LLC Before Purchasing A Rental Property
Another mistake to avoid is not having an LLC and EIN number in place before purchasing rental property. To protect your personal assets, make sure your mortgage and rental property title are under your LLC. Talk to your banker to see if your mortgage can be written using your LLC name rather than your personal name. It’s important to take these steps to avoid costly tax mistakes and keep your income and expenses organized and separated.
4. Did Not Do Proper Accounting For Start Up Expenses
Starting a new business comes with many expenses, but it’s crucial to understand which of those expenses can be deductible in the first year. These expenses are known as “startup expenses” and are defined as operational costs incurred before the business starts generating revenue. There is a limit of $5,000 for startup expenses and $5,000 for organizational costs, making a total of $10,000 in deductions if the total startup expenses do not exceed $50,000. However, if the total expenses exceed $50,000, the deduction will be reduced by a dollar for every dollar above the threshold.
5. Intermingling of Funds
Another common mistake made by LLC business owners is Intermingling of Funds, which can be seen as a red flag by the IRS and may result in a closer examination of the business’s operation and deductions. To avoid this, it’s important to properly categorize expenses and have proper documentation.
6. Categorizing of Staffs
In addition to expenses, it’s important to understand the difference between contractors and employees, as it affects payroll taxes. If a worker is considered an employee, the employer must pay Social Security and Medicare taxes on their behalf, while contractors are responsible for their own self-employment taxes. As a business owner, it’s important to consult with a CPA to determine the classification of your staff based on their role and authority in the company.
7. Keeping Poor Records
Keeping proper records is one of the most common mistakes made by Limited Liability Companies (LLCs). Good documentation is crucial when it comes to tax strategies, as it provides a clear trail of your financial transactions and can help you avoid potential problems with the IRS.
It’s important to document all of your deductions, sources of income, expenses, and any contracts or agreements that the IRS may want to review in the event of an audit. This includes invoices, receipts, paystubs, bank statements, and any personal expenses reimbursed by the business.
8. Accurate Documentation of Personal Expenses That Are Reimbursed
Having accurate documentation not only protects you during an audit, but also shows the IRS that you are a legitimate corporation, just like any other major employer. To ensure that your expenses are considered reimbursements, it’s a good idea to have a reimbursement plan in place, and to discuss this with your CPA. By doing this, you can make sure that each individual reimbursement is properly documented and meets the requirements of the IRS.
9. Forms To File
As a business owner and LLC owner, it is crucial to be aware of the forms that need to be filed. For single member LLCs, the most common form to be filed is Schedule C, which is where individual businesses report their business activity. Schedule C is part of the individual income tax return, Form 1040, and reports all sources of income.
On the other hand, multi-member LLCs are responsible for filing Form 1065, a separate tax return for businesses with a partnership structure. It is important to note that the deadline for Form 1065 is different from individual tax returns, being due on March 15th, whereas individual tax returns are due on April 15th.
To ensure that you file your business taxes on time, it is essential to be proactive and have all your business information ready before the end of the year. This will allow you to file in time before your individual taxes are due.
It is important for you as an LLC owner to understand the forms you need to file. One such form is the K-1, which you will receive from the taxpayer after they prepare your business tax return. The K-1 form is used to report your business activity on your individual tax return. Another important form is the SE tax dashboard, which you will use to file for your EIN number.
It is your responsibility to file form W-9 if you pay someone more than $600 in a year for business services that they did not perform as an employee. This form informs the IRS of the amount you are paying to other contractors or businesses. You will also need to issue a 1099 form to contractors at the end of the year to show how much they have been paid for the services they rendered. The W-9 form should be filled out by the contractors prior to performing work for you and kept on file.
10. Not Consulting An Accountant
Finally, a common mistake made by LLC owners is not meeting with their CPA and being unaware of the tax strategies available to them. To ensure you are maximizing your tax benefits, it is important to be knowledgeable and work closely with your CPA.
As your business grows, it’s crucial to effectively manage your finances, including your taxes. By being proactive about your tax savings and strategies, you can have control over what is often a significant expense in your business and personal life. To make the most of your tax opportunities, it’s important to work with a strategic CPA who can provide value beyond simply preparing your taxes. Don’t settle for a tax preparer who doesn’t add value – instead, choose to work with a CPA who can advise you throughout the year.