What are the possible tax advantages of an LLC?
The LLC is a sort of hybrid between a sole proprietorship or partnership and a corporation. So, it offers the best of both worlds, providing liability protection for business owners without intensive compliance obligations. For many companies, it can deliver significant tax benefits as well. Here’s why.1. Pass-through simplicity
By default, a single-member LLC (with a sole owner) is taxed like a sole proprietorship. The IRS considers the LLC a disregarded entity, so it is not a taxpayer in its own right. Instead, all business profits and losses flow through to the LLC member’s individual tax return. A multi-member LLC (more than one owner) is taxed as a partnership, with all profits and losses flowing through to the LLC members’ tax returns. Each member is responsible for reporting their share according to how members agreed to divide income and losses (which should be explained in the LLC Operating Agreement).- Single-member LLC owners report their business income and expenses on Schedule C of their Form 1040.
- Multi-member LLC owners report their share of business income and expenses on Schedule C of their Form 1040. The LLC files an informational return (Form 1065) and issues each member a Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc.).
- The amount of tax due depends on the LLC member’s personal tax rate.
2. Tax flexibility
An LLC may elect to be taxed as either an S Corporation (if it meets the IRS eligibility requirements, such as having 100 or fewer members) or a C Corporation. One reason business owners opt to elect one of these tax options is to minimize their personal tax liability for Social Security and Medicare taxes. LLC owners must pay self-employment taxes (12.4% of taxable income for Social Security and 2.9% for Medicare) because they are not considered company employees and receive no paycheck from which those taxes are withheld. However, when electing to have their LLC taxed as an S Corporation or C Corporation, business owners who work in the business are put on the payroll and therefore pay Social Security and Medicare taxes only on their wages and salaries (half withheld from their pay and half paid by their company). What’s particularly nice about S Corp and C Corp elections is that despite the alternate tax treatment, an LLC still retains its administrative simplicity—i.e., its ongoing compliance requirements remain that of the underlying LLC (it does not have to elect a board of directors, adopt bylaws, etc.). Most states honor the S Corporation or C Corporation elections made with the IRS; however, a few states require separate filings.An overview of S Corporation tax treatment
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The LLC must file Form 2553 to elect to be treated as an S Corporation for federal income tax purposes. As an S Corporation, an LLC remains a pass-through entity, thus retaining a simplified tax filing process and avoiding the double taxation that occurs with C Corporation taxation. An LLC with S Corp election files an informational tax return (Form 1120S) with the IRS and sends its members a Schedule K-1 form indicating their share of the profits and losses. The S Corporation’s members (considered shareholders for tax purposes), report their share of the company’s profits and losses on their individual tax returns.
The LLC must file Form 2553 to elect to be treated as an S Corporation for federal income tax purposes. As an S Corporation, an LLC remains a pass-through entity, thus retaining a simplified tax filing process and avoiding the double taxation that occurs with C Corporation taxation. An LLC with S Corp election files an informational tax return (Form 1120S) with the IRS and sends its members a Schedule K-1 form indicating their share of the profits and losses. The S Corporation’s members (considered shareholders for tax purposes), report their share of the company’s profits and losses on their individual tax returns.
An overview of C Corporation tax treatment
If taxed as a C Corporation, the company does not pass income and losses onto its members (considered shareholders for tax purposes); instead, it files its own tax forms and pays its own business taxes. An LLC that elects C Corporation tax treatment files Form 1120, U.S. Corporation Income Tax Return. If the LLC chooses to disburse profits to its members as dividends, the dividends are reported on the owners’ tax returns. You’ll hear this called “double taxation” because those dividends are essentially taxed twice: once to the business shareholders at the qualifying dividend rate and to the S Corporation at the corporate income tax rate before being distributed to the company’s owners. You may wonder why any entrepreneur would choose the C Corporation election, given that some income is taxed at both the individual and entity levels. Depending on how much income LLCs must report and the corporate tax rate compared to the individual tax rate, in some instances, corporate taxation may yield a lower tax burden than pass-through taxation.
How can you tell if the LLC structure will help you save on taxes?
There is no one-size-fits-all answer as to what business entity type is ideal for your situation, and business structure is just one of the many factors that can affect your tax obligations. It’s helpful to consult an attorney and tax professional for expert guidance on the legal and tax considerations of your options. The more you understand about how your choice of business structure and other factors will impact your company and personal situation, the better able you will be to make a confident decision.
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