If you’re starting a business, one of the first decisions to make is the type of business entity to form. A limited liability company (LLC) is an increasingly popular business structure for startups, offering liability protection for ownership and greater flexibility than a corporation, particularly in terms of taxes.
An LLC offers its owner or owners, who are called members, considerable flexibility in terms of management. You can choose your management and operational structure and decide how you want to be taxed. Your LLC can have a single member or multiple members, all of whom have personal liability protection, meaning your personal assets are not at risk if you cannot pay business debts or are involved in a lawsuit.
Tax Advantages of an LLC
An LLC is considered a “pass-through” entity, meaning income passes through the business to the owners for tax purposes. The LLC is not a taxable entity, so all income is reported on the tax return of the owner or owners and taxed at their personal income tax rate.
In the case of corporations, business revenue is taxed as are the dividends shareholders receive, which is sometimes referred to as double taxation. LLC owners also may be eligible for the 20% pass-through deduction that was part of the Tax Cuts and Jobs Act, meaning they can deduct up to 20% of business income.
LLCs are unique in terms of taxation as their owners have a choice about LLC tax classification. By default, an LLC is taxed like a sole proprietorship if it has one member and a partnership if it has more than one member. In both cases, business income “passes through” to the members, who report profits and losses on their individual tax returns.
Note that a multi-member LLC must file form 1065 with the IRS, which is the U.S. Return of Partnership Income. Attached to this will be form K-1s for each member showing their share of the business income.
But LLC owners can instead choose to be taxed as a corporation. To do so, the LLC must file a document, referred to as an election, with the IRS. The LLC must then decide if it wishes to be taxed as an S corporation or a C corporation.
C-Corp status means profits are taxed at the current rate for corporations (21% as of mid-2022), which is significantly lower than the typical individual taxpayer rate. But keep in mind, C-Corp shareholders, which includes members, must also pay taxes on their distributions (but not self-employment taxes). Thus, the C-Corp, like a corporation, faces double taxation.
As with sole proprietorship and partnership status, S-Corp taxation considers the LLC a pass-through entity, which means income passes through the company and into the hands of the owners. At that point, taxes are applied at the same rate as those of individual taxpayers.
S-Corps use Form 1120S to file their taxes, which is used to report the income, losses, and dividends of S-Corp shareholders. S-Corp shareholders do not pay self-employment taxes, which is the primary advantage of S-Corp status compared to sole proprietorship or partnership.
Generally, S-Corp tax status is beneficial if the company is profitable enough to pay the owners a salary and at least $10,000 in annual distributions so the owners can be taxed as employees and not pay self-employment taxes. It costs more to run an S-Corp than an LLC due to additional bookkeeping and payroll expenses. Thus, the tax benefits should be more than the additional costs for an S-Corp status to make financial sense.
LLC Tax Deductions
With an LLC, you can generally deduct your startup costs from your taxes. This means that any expenses that you incur to get your business up and running can be deducted. You can also deduct your ongoing operational expenses such as cell phones, internet, software expenses, rent, utilities, business meals, and auto expenses.
Tax Disadvantages of an LLC
Self-employment Taxes are Required
Members of an LLC are considered self-employed and must pay self-employment tax which goes towards Medicare and Social Security.
All Profits are Taxed
With an LLC, you will decide how much to pay yourself. You can distribute all profits, some portion of profits, or none. However, you still have to pay taxes on all the profits of the LLC, whether they are distributed or not.
Many new business owners choose to form an LLC because of its many advantages, particularly the tax advantages and the personal liability protection. If you’re still not sure if an LLC is right for you, consult with your tax advisor to make sure you make the right choice.