Limited liability corporations allow owners to avoid corporate taxes and have the earnings of their company taxed as personal income instead, much like how income in partnerships are taxed.

Limited liability corporations have been around since the late 1970s, and were first established in Wyoming. The concept, modeled after a German business structure, was challenged by the IRS, but in 1988 the IRS made a ruling that it would tax LLCs as partnerships. This opened the floodgates for more states to adopt LLC legislation, and by the late 90s nearly every state in the U.S. had passed LLC acts. In 2009, there were more than 1.3 million LLCs in the United States.

LLC profits are taxed to company owners as individual income, although LLCs can choose instead to have the income taxed as corporate income (few ever do).  LLC owners are required to report the profits and losses of the LLC to the IRS each year and report their income from the LLC too. In addition to federal income tax, LLC owners may also be required to pay self-employment and state income taxes.

Another key benefit of limited liability corporations is that they reduce the owners’ personal liability for the business. This can keep business owners from losing personal assets if the business has heavy debt and fails or if a substantial judgement is levied against the business in a lawsuit.

Filing requirements

If you’re the sole owner of your LLC, your income will be treated like that of the owner of a sole proprietorship. You’ll need to report your business’ profits and losses on IRS Schedule C, and submit that form along with your individual tax return.

If your LLC has two or more partners, you’ll need to file an informational return, much like partnerships have to do, as well as your individual income tax return.

All LLCs must submit a copy of Form 1065, which is used to report partnership income. They’ll also need to submit Schedule K-1, which details how profits and losses are divided up among LLC owners. Each member must receive a copy of Schedule K-1 before it is submitted to the IRS.

Much of the time, members of an LLC each have an equal share of the LLCs profit and losses, but one feature of the LLC is that it allows for unequal division of profits and losses if the owners chose. This structure may be used to reward a managing partner for his or her contribution to the business.

Using the information from Schedule K-1, owners of the LLC will report their income from the LLC on their personal income tax form by using Schedule E.

With regard to payment, members of an LLC will need to estimate their annual taxes and make payments each quarter. Failing to make quarterly payments could result in penalties.

Paying self-employment taxes

Although using an LLC business structure helps you avoid getting hit with income taxes twice, it doesn’t excuse you from payroll taxes. Members of an LLC who earn more than $400 in profit from the business over a year are required by law to make contributions to Social Security and Medicare. These deductions are determined by the self-employment tax.

The self-employment tax is 15.3 percent – 12.4 percent for Social Security and 2.9 percent for Medicare. Recent payroll tax holidays have reduced the Social Security tax somewhat, and as of this writing negotiations concerning an extension of the holiday are ongoing.

The Social Security portion of self-employment tax is capped at $106,800. This means that you only pay the 12.4 percent tax on your first $106,800 of earnings. The Medicare tax of 2.9 percent is levied on all income.

Typically, only partners who are actively engaged in the  operation of the business pay self-employment taxes. Owners who merely invest in the business and are not active in its operation are exempt from self-employment taxes in most instances. This issue can be thorny with tax officials, so it is wise to seek the advice of a tax professional in determining whether you must pay self-employment taxes if you are a partner in a limited liability corporation.

If you must pay self-employment taxes, you can deduct half of them from your taxable income at the end of each year.

Paying state taxes

The federal government more or less treats LLCs as partnerships for taxation purposes, but each state has its own way of dealing with LLCs and their tax status. Most states have policies similar to the federal government, giving LLCs pass-through status on taxes similar to that of partnerships. Other states treat them as partnerships in some respects, but levy additional taxes on LLCs.

The majority of states collect income taxes from members of LLCs based upon their share of business profits, just like the IRS does. In most cases, sole owners of LLCs will have to file tax forms similar to those of sole proprietorship business owners, while LLCs with two or more owners will need to file tax forms similar to those of partnership business owners. Also, much like federal income taxes, state income taxes must be paid on a quarterly basis.

Some states also impose annual feeds and other taxes on LLCS, such as franchise taxes, surcharge taxes, annual fees, etc. The amount of these taxes can range anywhere from $10 to many thousands of dollars.

The best way to determine what taxes your LLC will need to pay in your state is to contact your state’s revenue department and inquire.

LLCs can be an extremely advantageous business structure because of the tax and liability advantages it grants owners. Understanding the tax advantages of an LLC can better help you decide if this is the right structure for your new business.

Consider this: Nearly 40 percent of small businesses incur IRS penalties of about $845 per year because of payroll tax errors. And that’s just one area of your business subject to tax law. While many small business owners dream of being a part of the “one percent,” not the 1.5 percent of business owners subjected to an IRS audit each year. Here are a few ways to help keep you out of tax trouble and out of the IRS’ crosshairs:

1. Poor record keeping – Be sure that you keep receipts for all expenses, particularly meals and entertainment over $75. That way, if the IRS asks you for documentation of your deducted business expenses, you’ll be able to produce it. IRS rules require that you keep receipts for three years after the tax return they apply to has been filed. By keeping the receipts you need, you’ll be in good shape if the IRS demands an audit.

2. Not keeping a tax diary – A detailed and accurate tax organizer can go a long way toward helping you answer questions revenue officials may have about your claimed expenses, such as travel and entertainment. A good tax organizer should run about $100, and in light of the hassles and large costs you could pay as the result of an audit, it’s a great investment.

3. Tapping into employee tax withholdings in hard times – Diverting money from the tax withholdings you’re supposed to make from employee paychecks can be a big temptation for business owners in dire straits. Many business owners have done this, treating the money as a temporary loan to their businesses. The risk is not worth the reward, however, as the business owner is held personally liable for this money and could incur substantial penalties if caught by the IRS.

4. Missing common deductions – Remember that many expenses that you incur can be tax deductible. If you work from home, a portion of your mortgage or rent and utility bills may be deducted from your taxes. If you’re on the road frequently, dry cleaning and entertainment costs for business associates can also be tax deductible. Frequently review your expenses and tax rules as the regulations concerning what’s deductible can change fairly often.

5. Failing to oversee bookkeepers and accountants – While you may not be a financial expert, you should take the time to give a cursory look at your books and tax returns to ensure no big mistakes or questionable items are entered. Also, be sure to not use the same person as your bookkeeper and accountant, as having two sets of eyes on your finances reduces chances of fraud and error.

6. Miscalculating automobile expense deductions – This deduction causes a bit of confusion because business owners can use either a mileage formula to come up with their deduction or they can tally up the actual expense of using the automobile. The mileage deduction is easier to calculate, but if your car depreciates in value significantly or has incurred significant costs, the more difficult to calculate actual expense may be a more advantageous method.

7.  Putting equipment and supplies together  – Equipment should not be lumped with supplies as the rules governing deductions are different for equipment and supplies. Most small businesses are allowed to deduct up to $24,000 in capital expenses, which includes equipment. When deducting equipment, you must determine the depreciated value of the equipment before claiming your deduction. Supplies, such as paper, printer ink, etc. can be deducted without this calculation.

8. Incorrectly classifying employees as independent contractors – Employees work for you directly, independent contractors work for themselves or a company contracting with yours. It’s very tempting to classify workers as independent contractors, as you won’t have to pay employment taxes on them or deal with the burden of withholding payroll taxes. However, if you classify workers as independent contractors, and the IRS decides that they would be more properly classified as employees.

9. Late payments – Don’t forget that your taxes are due on a quarterly basis. Businesses that wait until April 15 to pay their taxes could face substantial penalties for late payment. By following “pay as you go” rules, you can avoid penalties and make the April 15th tax filing deadline a little less dreadful.

10. Failing to report large cash transactions – The IRS requires that cash transactions of $10,000 or greater be reported on Form 8300. This includes cash transactions spread out over a period of time for the same item or service that add up to more than $10,000. This rule is intended to hinder money-laundering efforts by drug and organized crime operations and terrorists.

Even if you’re a math whiz and great at spotting deductions, you still may want to get your business’ tax returns scrutinized by a tax professional, as they likely will have superior knowledge about tax rules and what’s deductible.

By making sure that you follow all tax rules and regulations, you can help stave off audits and tax headaches from government officials and also avoid the large penalties that may be assessed against your business as a result of non-compliance with tax laws.

The cost of paying legal fees or accounting fees for your business may also be deducted from your taxes. These are considered essential for your business and are only used for your business. You are not using them for your own personal good. If you use the same legal or tax advisor, you will want to obtain records that are separate for each entity. You can also deduct the use of your car or any other motorized vehicle that is strictly used by the business. If you use your car for your business, you must carefully observe how much distance is taken from your place of business to the place where you are doing the job. That is the amount that can be deducted from your tax. Using your car simply to get to work does not count.

If you are traveling for your business you can deduct the amount that it costs you of getting lodging or other expenditures. If you are entertaining clients also you are able to deduct this. The amount that you are able to deduct from entertaining clients is only 50% though. If you want to give them gifts, the maximum amount you are able to spend is $25. Keep a record of all money spent especially when it comes to these as when if a business is audited these are the two most likely to appear as questionable. If you have all the paperwork available it is more likely to be dismissed.

Any software that you need to buy for your company as well as other essential equipment can be written off. Generally software is said to have depreciated completely in value over 36 months. Until December 31, 2010 any software bought off of the shelves in store will be deducted 100% off of the company taxes. Computer hardware if valued under $133,000 is also 100% tax deductible for the year.

If you sell goods, any goods that are not sold can be deducted as a business expense. If you are not able to sell them, then you did not make a profit. If it is shown that the amount of goods you did not sell is greater than the amount of goods you did sell for over 5 years, the chance of you being audited greatly increases though so it is not wise to overstock on items.

Your business is also able to give a charitable contribution which will count as a tax deduction . Many businesses give generous donations towards the end of the year especially if they have made a larger than normal profit so that they will not have to pay as much in taxes.

Any education that you may have received or have given to employees so that the company was better able to run can also be deducted. These are considered essential for the company to work. If you do not have properly trained employees then you will not be able to attract more customers to your business.

On your loans for your business you are able to deduct the interest from them. While this may not seem like much it will save you in the long term from having to pay a huge amount.

If you are running a home based business , there are other tax breaks that you may find. For example, you are able to deduct a portion of your home expenditures to cover the cost of having an office in your house. You will also be able to deduct utilities as they pertain to your business. If you do choose to deduct a portion of your home as your business, you must be prepared to present many documents in order to back up your claim.

No matter where your business is based you are going to be able to find tax breaks so that you are able to save as much money as possible. You do not want to have to pay more money than what you need to. It’s your money and you deserve to keep as much of it as possible.