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.
Choose how to be taxed
LLCs are unique in terms of taxation as their owners have a choice about how the company will be taxed. 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.
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.
Some states require all corporations to pay a franchise tax but do not require the same of LLCs. This can be a significant tax savings. Check with your state tax department to see if LLCs are required to pay a franchise tax in your state.
Tax Disadvantages of an LLC
Members of an LLC are considered self-employed and must pay self-employment tax which goes towards Medicare and Social Security.
All profits 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.
Other Benefits of an LLC
An LLC is simple to form, requiring much less paperwork than a corporation. You only need to file articles of organization and have an operating agreement to define ownership and roles and responsibilities. There are no annual meeting or reporting requirements, as with a corporation, and you don’t need a board of directors. In some states, however, you do have to file an annual report for an LLC.
It’s also less expensive to form an LLC. Corporations and partnerships are best formed with the assistance of an attorney, which is expensive. It is a good idea, however, to have your LLC’s operating agreement reviewed by an attorney. Corporations also pay fees for their required annual filings.
In an LLC, you can be the only owner, just like a sole proprietorship, and have full control of the business. With more than one owner, you can structure the management any way you choose with your operating agreement. You don’t have to answer to a board of directors or anyone else. You have more freedom to make decisions than you do in another type of business structure, other than a sole proprietorship.
Limited Personal Liability
Unlike a sole proprietorship, an LLC is considered a legal entity that is separate from you, the owner. Just as in a corporation, your personal assets are protected because you’re not personally liable for the company’s debts or legal liabilities.
In a sole proprietorship or general partnership, your personal assets such as your home are at risk if there are unpaid debts or legal liabilities. There are some instances in which an LLC owner, however, could have personal risk. For example, if you’re asked to personally guarantee a business loan, you’re personally liable for the debt.
Most businesses split profits based on the capital contributions of owners. In a partnership, profits are generally divided equally. Corporations pay dividends based on the ownership percentage of the shareholders.
In an LLC operating agreement, the owners can specify any profit-sharing plan they choose. One owner can take a percentage share of profits greater than their ownership interest, while other owners take less. This may be done in a case in which one owner is more involved in business operations than others.
An LLC has the advantage of having more credibility to customers and vendors than a sole proprietorship. As a matter of perception, people tend to see an LLC more as a more established company, as opposed to a one-person show.
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.