LLC Pass-Through Taxation: How Does it Work?

Forming a limited liability company (LLC) has many benefits, including personal liability protection, but also tax flexibility. LLCs, by default, are pass-through entities for tax purposes.

This guide provides all the information you need to understand pass-through taxation and how it impacts your LLC. 

What Is “Pass Through” Taxation? 

By default, profits and losses pass through the LLC to the owners, also known as members, who report them on their individual tax returns. The LLC itself is not taxed, which simplifies the process. 

The losses and operating costs of the business are instead deducted from the members’ personal taxes, with taxes paid at each member’s personal tax rate.

If an LLC has only one member, it will, by default, be taxed as a sole proprietorship. If an LLC has more than one member, it will, by default, be taxed as a general partnership. In both cases, profits and losses again pass through to the member or members.

Benefits of Pass-Through Taxation 

Pass-through taxation has several benefits.

Avoid Double Taxation

Again, pass-through taxation means that the LLC itself is not taxed. In contrast, a corporation is taxed at the corporate tax rate. Dividends paid to shareholders of the corporation are also taxed, which is known as double taxation. This is one of the main reasons many new business owners choose to form an LLC rather than a corporation.

Flexibility

One of the unique features of an LLC is the choice of taxation. If your business grows to a certain point, it may be financially beneficial to elect to have the LLC taxed as an S-Corporation or a C-Corporation. The main reason to do so is to avoid self-employment taxes, which LLC members are responsible for when the LLC is a pass-through entity.

Combining personal and business income for tax purposes 

In a pass-through entity, all of your personal and business income are combined, so you have one tax return and one tax bill. This can simplify things for you at tax time and make handling your business and personal finances easier.

Do I Have to Choose Pass-Through Taxation?

Pass-through taxation is the default status for LLCs, but again, you can choose to have your LLC taxed as an S-Corporation or a C-Corporation.

With S-Corp status, the LLC itself is not taxed, but must file form 1120S, the U.S. Income Tax Return for an S-Corp. Revenues again pass through to the owners, who must receive a “reasonable salary“, as defined by the IRS, before taking any profit distributions from the LLC. 

Members will be responsible for employment taxes on their salary but not for self-employment taxes on distributions taken above and beyond that salary. This, in fact, is the main reason business owners choose S-Corp status – to avoid self-employment taxes on distributions.

But keep in mind that S-Corp status comes with additional administrative requirements, which means added costs, such as payroll expenses.

C-Corp status means profits are taxed at the current rate for corporations (21% as of early 2023), which is often lower than the typical individual taxpayer rate. But C-Corp shareholders, including members, must also pay taxes on their distributions, though not self-employment taxes. 

Thus, the C-Corp, like a corporation, is subject to what is referred to as double taxation. Determining if S-Corp or C-Corp status is the right move is tricky, so you may want to consult with a tax advisor.