Transcription
Forming an LLC is a business power move that shields your personal wealth and helps you avoid double taxation. But key LLC mistakes can turn that power against you. I'm Carlton Dennis, the founder and CEO of Tax Alchemy, and today I'm going to break down the top five LLC mistakes that derail your business. Avoid them at all costs so you can build your wealth strategically. Let's dive in.
All right, mistake number one is not using your EIN for income and expenses. Your EIN, or your Employee Identification Number, acts like your business's social security number. It's the nine-digit number issued by the IRS that identifies your company for tax purposes. Every business needs an EIN if it plans to hire employees, open up a business bank account, or even establish business credit. Here's why most new business owners stumble. They get an EIN number, but they never actually use it. This is one of the biggest mistakes in business, and it can lead to serious problems down the line.
But once you do have your EIN, the first thing that you should do is open up your business bank account using that number, not your social security number. So from that point on, all income earned by your LLC should flow into this account. And all business expenses should come directly out of this account, too. This separation is crucial in business. Why? Because keeping personal and business finances separate protects your liability and it shields you. If you mix personal and business funds together, what we call in the tax space is commingling, you risk losing the legal protection that the LLC provides. Imagine getting sued and the court is deciding that there's no real distinction between you and your business. Suddenly, your personal assets, such as your home, your car, and your savings could be on the line. That's exactly what liability protection is meant to prevent.
But using your EIN number and a business account makes life easier if you want business credit as well. You see, banks and lenders want to see proof that your business is making consistent money. Without a business account tied to your EIN, it's nearly impossible to provide that proof. I've seen this happen countless times during the pandemic. Many clients applied for PPP loans or EIDL disaster loans. A surprising number were denied, not because they weren't making money, because they never properly used their EIN or opened up a business bank account. Their finances weren't organized enough to demonstrate consistent revenue through their business to justify a loan.
So, here's the takeaway. Get your EIN and open up the business bank account with your EIN and always use it for every business transaction. It may seem simple, but it's a foundational step that many new business owners overlook.
Mistake number two is not understanding the type of income your LLC generates. This is a critical mistake because the type of income your LLC earns determines how you should structure your business and how much tax you will owe. Not all income is taxed the same, guys. And understanding the differences is thousands of dollars in savings that you could have.
There are three primary types of income you could receive if you're an entrepreneur. Ordinary income, passive income, and what we call portfolio income. Ordinary income is number one. It is the money you earn by working, exchanging time for money. This includes W2 wages, 1099 contractor income, or any income that comes from services that you actively provide. So, if your LLC earns ordinary income, it's subject to self-employment tax, which is 15.3% Social Security and Medicare taxes, federal taxes, and state taxes. Here's the challenge. The more you earn, the heavier that tax burden becomes. For most new LLC owners, earning ordinary income, the self-employment tax is manageable initially, but once your profits exceed $50,000 per year, the 15.3% starts to take a significant bite of your earnings. That's why many LLC owners consider switching to an S corporation once their business hits a certain income threshold. With the S corporation, you pay yourself a reasonable salary, which is taxed for Social Security and Medicare only on the salary. And then your remaining profits are distributions, which are not subject to self-employment tax. So, this is the part right here that saves you the thousands of dollars in taxes every year, not subjecting the distributions to self-employment tax. The key point here is that you need to understand your LLC income type before forming an LLC at all. If your income is ordinary and growing, planning ahead for a potential switch to an S corp can prevent unnecessary tax expenses.
Now, the second type of income is passive income. This is money you earn without actively working day-to-day. A common example is rental income for long-term investment properties. The big advantage is that passive income isn't subject to Social Security and Medicare taxes. You're not working, so it's not subject to that. That's why my firm frequently sets up LLCs for real estate investors. We allow them to protect their assets, separate their business finances, and reduce certain tax obligations by being structured. If your LLC will generate passive income, knowing this ahead of time will help you to structure your business correctly and take advantage of all the available benefits that you have out there in the tax code.
But the third type of income that you could be earning is called portfolio income. So, portfolio income is derived from investments. I'm talking capital gains, dividends, bonds, and interest payments. Plus, you might have some stocks. Most entrepreneurs don't start with portfolio income. It typically comes later. After the business generates enough profit to invest is when we start hearing about portfolio income. But the best structure for portfolio income depends on the type of assets being invested in, whether the business is generating other forms of income, and what are your long-term financial goals. This is more nuanced than ordinary or passive income where it's very straightforward. So, it becomes more of a conversation with a tax professional during a consultation when you're dealing with portfolio income through an LLC.
But here's mistake number three. Not knowing which tax forms to file. Easily mistake number three because a lot of new business owners hire CPAs who just simply fill out forms without explaining the process. But if you're a serious business owner, or at least you're serious about your money, you need to understand the key tax forms that apply to your LLC. So, here's a breakdown of the most important forms you should know before you even think about hiring anyone.
An SS4 form. This is what you use to apply for your EIN. Without this, you can't open up a business bank account or build business credit. Think about that.
Next is a Schedule C. This is for sole proprietorships or single-member LLCs. It reports all of your business's profits and all of your expenses, and it goes inside of your personal tax return. Your personal tax return is called a 1040. This form gives the IRS a clear snapshot of your business profits for the year. Pretty simple so far, right?
Here we go. Form 1065. All right. Now, we have a partnership. This is a separate tax return filed by the partnership itself, in addition to each partner's personal tax return.
Now, we have what's called a K1 form. If you're in a partnership or an S corporation, the K1 reports each partner's share of income or loss. This allows the income to pass through to personal returns. So, you only pay taxes once at the individual level.
And then you have the W9 form. It's used when hiring contractors. So, if you pay an independent contractor over $600 a year, they fill out a W9, allowing you to issue them back a 1099 at the end of the year so they can report their income.
Many new LLC owners skip one or more of these steps simply because they don't understand the importance of them. Understanding these forms is not just about compliance or me trying to help you sound smart. It's about making sure your business runs efficiently and your finances are organized.
But what about mistake number four? Buying real estate before starting an LLC. This is a big one in the real estate world. Many new investors come to me after buying a property and then they ask, "Carlton, should I set up an LLC now?" My answer is always, always, it's better to form an LLC first. Why? Because when you purchase property through your LLC, the property is officially owned by the business, not by you personally. This gives you a layer of protection, a layer of privacy, because your name doesn't appear on the public property records, and it also protects your personal assets in the event there's ever a liability issue.
If you buy property in your personal name and then you try to transfer to an LLC later, you could run into major problems. Many mortgages include a "due on sale" clause, which means the bank could demand full repayment of the mortgage if ownership is transferred. Imagine having to come up with hundreds of thousands of dollars unexpectedly because you didn't time things correctly or you just didn't know. Additionally, transferring property later may require a quitclaim deed, which can be a little bit complicated under certain circumstances or trigger new taxes or transfer fees. So, starting with an LLC makes the process cleaner, it makes it simpler, and it makes it much safer for you.
Before purchasing any rentals or investment properties, always talk to a tax professional. You want to confirm that your lender allows LLC ownership, that your LLC is fully prepared to take on the property. Doing this step right from the start avoids headaches and potential financial mistakes.
Mistake number five, not knowing how to reimburse yourself properly. This is one of the ones that gets overlooked. I think many entrepreneurs pay for business expenses with personal credit cards all the time and then they never reimburse themselves correctly. Ideally, all business expenses should be paid for with a business account and a business credit card. But we don't live in a perfect world. Some mistakes happen. And if you accidentally use your personal funds, the solution is what's called an accountable plan. An accountable plan allows your LLC to reimburse you for legitimate business expenses you initially paid for personally without creating taxable income. The key is proper documentation. So, you're going to have to keep detailed records of receipts, invoices, and the business purpose of each expense. But, you're doing this already, right? When done correctly, this keeps you compliant and it preserves your liability protection.
Here's a bonus. We've already covered five of the most crucial LLC mistakes to avoid at all costs. I'm going to give you two bonus mistakes to avoid. Here they are.
Number one, neglecting business credit. You see, a business bank account isn't just for separating funds. It's the foundation for loans, credit cards, and lines of credit that can fuel your growth. We use credit all the time in our business. Without a strong business credit history, you may struggle to get financing when opportunities arise. So, building credit early also helps secure better interest rates and terms on future loans. How about strong business credit signals reliability to vendors and partners? That can open doors for better payment terms and business relationships. It also gives your LLC more flexibility in scaling operations without relying solely on personal credit.
Here's the number two bonus I want to give you. Skipping consultations. See, you think you understand LLCs. Talking to a professional ensures you avoid hidden pitfalls, though. A knowledgeable advisor like myself can identify risks you might overlook and recommend strategies tailored to your business. So, investing a little time upfront can save you a significant amount of money and stress down the road. Professional guidance can help you optimize your LLC for taxes, liability protection, and growth strategies from day one. It also provides peace of mind knowing that you're making informed decisions instead of guessing along the way.
But here's my final takeaway. Yes, forming an LLC can be one of the best decisions you ever make as a business owner, but only if it's done correctly. Avoiding these common mistakes we talked about is important. Using your EIN number, understanding your income type, forming the LLC before buying real estate, knowing which tax forms to file, reimbursing yourself properly. Business owners get this wrong all the time. So, if you can get this right, you're on the right course. But you need to take the time to get these steps right so you save money and you prevent headaches later as you scale.
If you want professional guidance to set up your LLC for maximum protection, tax efficiency, click the link below to schedule a free consultation with my team. And let's make sure your business is built on a strong foundation from day one.
Okay guys, that's all I got for today's video. As always, don't forget to like, comment, and subscribe to the channel. And I will see all of you guys on our next video. Cheers.