Transcription
Having an LLC can help new business owners limit their liability and avoid double taxation. But if you make certain key mistakes, it can have a profound negative impact on your business that can slow down your growth and get you into trouble with the IRS. My name is Carlton Dennis. I'm a licensed tax strategist and enrolled agent, and in today's video, I'm going to tell you all of the key mistakes that you need to avoid before setting up your LLC. If you're at the end of the year 2024 or heading into 2025, if you are trying to build a business that will be successful, look no further than this video.
Mistake number one: Not using your EIN number for your income and expenses. EIN stands for employer identification number; it's a nine-digit number that is issued by the IRS to your business so that the IRS can keep track of your business's tax accounts. But unfortunately, many LLC owners simply do not use their EIN numbers, and this is a huge mistake. Once you get an EIN number from the IRS, you should take this number and open a business bank account. Your income from your LLC should flow into this bank account, and your expenses should be paid from this business bank account. You see, the main reason why this is the case is because, as an LLC owner, you want to keep your business income and expenses separate from your personal income and expenses. This helps to prevent the co-mingling of funds, which could hypothetically lead to a loss of liability protection. Considering that liability protection is one of the main benefits of opening an LLC in the first place, you definitely don't want to lose this protection. If the government can't tell which funds are personal and which funds are business, then it might just allow all of the funds to be seized, which you do not want in a lawsuit or an IRS matter. Accidentally co-mingling business funds and personal funds is bad, but it's not the only reason that you should actually use your EIN number and set up a business bank account. Another critical reason is that if you ever want to attain business credit, such as a business loan or a simple credit card from American Express, lenders will want to see an income history report. This means that they want to see proof that your business is actually making money consistently. It is far easier to obtain business credit if you have a business bank account with proof of income and expenses. Consider this: during the pandemic, a lot of my clients were asking me, "Carlton, why was my application for a PPP loan or EIDL loan (economic injury disaster loan) denied?" Well, for a lot of these people, it was because they never used their EIN and didn't open up a business bank account. Now, hopefully, we won't be dealing with any more pandemics for the foreseeable future, but the principle is the same: if you want to qualify for business loans and lines of credit, you have a much higher and better chance if you're actually using the EIN number that was issued to you by the IRS and have a business bank account that proves your income and business expenses are linked to your EIN. All right, let's move on to mistake number two.
Mistake number two: Not understanding your income type. You see, a lot of LLC owners set up their LLCs without understanding which type of income they will receive and how that income impacts taxation. Here's the thing: the type of income your LLC receives is extremely important and it could even impact whether you need an LLC, an S Corp, or a C corporation. Some people set up LLCs when they would actually be better off with a different entity structure due to the type of income they are receiving. Here are the three main types of income: Number one: ordinary income. Ordinary income is the income that you work for. This includes 1099 income as well as W2 wage income. If you'll be earning ordinary income through your LLC, it'll be subject to Social Security and Medicare taxes in addition to state and federal taxes. The self-employment tax of 15.3% covers both Social Security and Medicare. For many new LLC owners who have ordinary income, it's going to make sense to have an LLC until the business starts generating over $50,000 in business profit. This is because once your business starts generating over $50,000 in income, the self-employment of 15.3% tax is going to become more and more of a burden. It's not so bad at first, but it gets increasingly difficult to deal with as your business grows. Once your business starts to make more than $50,000 in income, it is going to make sense to switch to an S Corp in most cases, and this is because you can reduce your self-employment tax burden by splitting your salary into two portions: a salary portion and a distributions portion. Only the salary portion will be subject to payroll tax obligations, which can reduce your Social Security and Medicare tax burden significantly. So before you set up your LLC, you need to know if your business is going to be earning ordinary income, and if it is, you need to know that you might have to switch your entity structure once your earnings surpass $50,000 a year. Number two is passive income. Passive income is income you technically do not have to work for on an ongoing basis. A good example of passive income is income from a long-term rental real estate property. You see, what you need to know about passive income is that it's not subject to Medicare and Social Security taxes like ordinary income is. This is one of the main reasons why many companies use LLCs heavily for our clients who are involved in real estate investing. And number three is portfolio income. You see, portfolio income is income that is generated from your investment portfolio. This can include capital gains from the sell of stocks or bonds, and most new business owners do not start out only generating portfolio income. Portfolio income usually shows up down the line once the original LLC is successful and the business owner has made money to invest. Now, the best business structure for portfolio income depends heavily on the assets that are being invested in and whether or not the business is generating other types of income. This is more of a case-by-case basis and is heavily dependent on your specific situation.
Now, mistake number three is not establishing an LLC prior to making a real estate acquisition. All too often, people say to me, "Carlton, I just bought an investment property; does it make sense for me to have an LLC now?" This frustrates me a little bit because, for a lot of these people, it actually makes more sense for them to establish the LLC first before they buy the rental property. One of the main reasons I usually have my clients set up LLCs first before buying the rental real estate is because when you do this, you can buy the property under your LLC's name instead of your personal name. This dramatically increases your privacy. Another problem with buying a property under your own name is that this can make you personally liable for lawsuits against the rental business, and you definitely don't want that. I mean, just imagine going bankrupt because someone slips and falls at your rental property. You see, many people don't realize this until it's too late, and then they try to transfer the ownership of their property to a brand new LLC. While it's possible to do this with a quick claim deed, it can be very complicated. For example, some mortgages have a due-on-sale clause. This means that the entire mortgage can be due if ownership of the property is transferred. Obviously, this is not ideal. I mean, just imagine having to suddenly pay a million dollars to the bank because you want to switch your ownership from your own name to the name of an LLC. For this reason, if you're going to buy an investment property, I strongly recommend that you get in touch with a tax professional team that can at least advise you around whether or not an LLC makes sense for your situation. We need to make sure that your particular mortgage lender allows an LLC to take out a mortgage. We also need to understand all of the terms of the mortgage, and we need to make sure that the LLC is ready to assume the ownership of the property before the purchase is actually made.
Number four: Not knowing which types of tax forms to use. This is one of the most common mistakes that new business owners make, and it's honestly completely understandable. Many new business owners hire CPAs, but the CPAs are not doing tax planning, so they aren't walking business owners through every single tax form. The CPA just fills out the tax form on behalf of the business owner without actually educating the business owner or letting them know what is going on. So to make sure that you start your business without any headaches and you have an idea what tax forms you might need, I'm going to break down some of those key tax forms that you need to understand right away. The first one is SS-4 form. Remember at the beginning of the video when I was talking about that EIN number? Well, the Form SS-4 is the form that the LLC owner has to file with the IRS in order to apply for an EIN number. So don't make the mistake of not filing this form. This is how you obtain your EIN. You will need an EIN number to set up your business, make accounts, to build business credit. The number acts like a social security number for your business, and it's very important. All right, number two is a Schedule C. Schedule C is a form that reports 1099 income in excess of $400. This tax form will only represent sole proprietorships or single-member LLCs. The nice thing about this tax form is that it's just one page; it's very straightforward. So if you have a sole proprietorship or if you own a single-member LLC, then you will use this tax form to report your business income. It goes inside of your 1040 tax return. The forms show the government all of your income items and all of your expense items. This lets the IRS have a complete understanding of what your business profits were at the end of the year. And number three, the Form 1065. This is a partnership tax return. A 1065 tax form will be used to file if your business has partners in it, which means you have somebody else. If you're in a partnership, you will file a separate tax return outside of your personal tax returns. There are two tax returns, which is different than a single-member LLC, which would only have one tax return with a Schedule C. So when you have a partnership, you have a partner tax return and a personal tax return that both have to get filed. And number four, the Form K-1. We just talked about how you have to file a separate return if you have a partnership called a Form 1065. You might be wondering, "Well, how does the income get reported from 1065 to me personally?" Well, that's where the Form K-1 comes into play. When a partnership files its tax returns, it also submits Form K-1. This goes to all the partners of the business in addition to the IRS. This form represents the income and losses for each partner in a partnership. When you receive Form K-1, you can use this information on the form to fill out your personal tax returns where you're going to pay taxes only one time, and this is why I love partnerships: 1065, K-1. Number five is the W-9 form. The W-9 form is the form that you will need every time you hire a 1099 contractor and pay them in excess of $600. You issue these forms to your contractors, and they fill them out. This allows you to issue them a 1099 form at the end of the year. Now, this form is crucial to know about because many LLC owners hire a variety of contractors online to help them grow their businesses, and they forget sometimes. If you're hiring a marketing contractor, a construction contractor, a video editor contractor—these contractors that you pay more than $600 will need a 1099 form, so you have to provide them a W-9. A lot of new business owners skip over this, and it comes back to bite them in the butt. All of these forms I just gave you, I want you to be aware of them if you're going to be a new LLC owner. But if you need assistance with Form W-9 or any of the other topics I am discussing in this video, please make sure that you get in touch with my tax strategy team by booking a free consultation in the links below in the description.
Now let's move on to the last LLC mistake that I want you to avoid. Mistake number five: Not knowing how to reimburse yourself as an LLC owner. Many new business owners make the mistake of making business purchases with personal credit cards. The first thing that I will say about this mistake is that you should really try to avoid it. You can avoid it by making sure that you have a business credit card and you're always using these credit cards or writing checks from your business account when you make purchases for your business. This will make everything a lot easier on you. However, if you do accidentally make business purchases with your personal accounts and credit cards, then there is a way to reimburse yourself. You can do this with what's called an accountable plan. If you do end up using an accountable plan, it is crucial to make sure that you follow all the rules to make sure that your documentation is done correctly. My team can help you with this if you need assistance, but for now, it is important that you just understand that accountable plans exist and that it is how you reimburse yourself for business expenses that you accidentally made with personal cards or accounts.
Okay, before we wrap up this video, I'm going to answer just a quick question from one of my subscribers. This question was asked on a similar video that I made on a topic a few years ago. The question came from Tenit 4350—I'm sorry, I'm butchering it—but the question was, "First of all, thank you, this was eye-opening. Do you need a different LLC if you're doing both, let's say Airbnb arbitrage and vending businesses, or can I just use the same LLC for both? Does that change how I file my taxes?" If you're doing Airbnb arbitrage, which means you're renting out a property to tenants versus having a vending machine business, those are two separate types of businesses with also two separate types of liability. In one business, I'm providing food to people in a vending machine style, and another is I'm providing housing to people in a housing style. I personally believe that there's liability associated with the vending machine business that could revolve around the food and the products that people receive, and there's liability associated with my rental arbitrage business of tenants staying inside of a property that I'm leasing out from a different landlord. In my mind, because those two businesses are completely separate from each other, they're not one and the same. I personally would have two separate LLCs to keep those businesses separate from each other. In the event that something happened in my vending machine business, I am not liable to pay out debts if I have an LLC over here that has nothing to do with my vending machine business that's solely focused on rental arbitrage. Separating the liability from each other is the purpose of the limited liability company. I hope this helps you on your journey to building your wealth as you look to expand your business. Thank you guys so much for watching this video. If you enjoyed this video, I'd love for you to do something for me: go ahead and like, comment, subscribe, leave a comment around your LLC and what the purpose of it is for. We would love to help you grow your business here on this channel. Thank you so much, and I look forward to seeing you in the next video. Cheers.