One of the most popular ways to organize a business is creating a limited liability company, otherwise known as an LLC. The true advantage of an LLC over other business entity types comes in the form of tax benefits. LLCs give business owners significantly greater federal income tax flexibility than a sole proprietorship, partnership and other popular forms of business organization. If you own a small business or are starting one, it’s important to make sure your tax planning is done right. You can talk to a financial advisor to help you through the entire process and determine which business formation is right for you.
What Is the Main Tax Benefit of an LLC?
The key concept associated with the taxation of an LLC is pass-through. This describes the way the LLC’s earnings can be passed straight through to the owner or owners, without having to pay corporate federal income taxes first. Sole proprietorships and partnerships also pay taxes as pass-through entities. These businesses pay no federal income taxes themselves. Instead, their earnings are passed directly to their owners, who pay taxes on them at their individual income tax rates.
This is different from standard C corporations, which are subject to double taxation. More specifically, the corporation must pay taxes on its income. Then, any distributions to its owners are also taxed as individual income. Clearly, avoiding double taxation can save significant money in the long run. That’s one of the main tax benefits of an LLC.
Tax Flexibility of an LLC
An important feature of an LLC is that the Internal Revenue Service (IRS) allows business owners to choose the way their business will be taxed. They can choose to be taxed as a sole proprietor, a partnership, an S corporation or a C corporation. You choose how you’ll be taxed by filing IRS Form 8832.
There are some limitations on the aforementioned choices. An LLC with multiple owners can’t choose to be taxed as a sole proprietor, for instance. The IRS will automatically tax an LLC as a partnership if it has more than one owner. You can learn more about rules for taxing LLCs from the IRS backgrounder on Form 3402, covering the taxation of LLCs.
The table below breaks down four common to pay taxes for an LLC:
LLC Taxation Options
| Filing Status | How Income Is Reported |
|---|---|
| Sole Proprietorship | If you choose to set up your LLC as a sole proprietor, you’ll have to report whatever profit or loss the business generates on your personal tax return. You will file a Form 1040 individual tax form along with, usually, a Schedule C business profit or loss form for the LLC. |
| S Corporation | LLCs set up as S corporations file a Form 1120S but don’t pay any corporate taxes on the income. |
| C Corporation | If you elect for your LLC to be taxed as a C corporation, you’ll file the Form 1120 corporation tax return. Instead, the shareholders of the LLC report their share of income on their personal tax returns. This avoids double taxation. The corporation will have to pay a tax on profits. Members will report any of this income that is passed on to them on their individual tax returns as dividends or interest and, once again, pays taxes on it. Note that if the C corporation doesn’t pass some or all of its income through to members, they won’t have to pay tax on that income. |
| Multi-Owner Partnership | The LLC will file a Form 1065 partnership return. Each owner will pay taxes according to his or her share of the profits or losses, reporting this on Form 1040 and a Schedule K-1. |
Tax Limits of an LLC
It’s important to keep in mind that organizing as an LLC doesn’t mean you won’t pay any taxes. You’ll still have to pay taxes on income from the LLC at your ordinary individual tax rate. LLCs, depending on how you set them up, may not have to pay business taxes at first.
Unlike wages received from an employer, income from an LLC isn’t subject to withholding. In turn, you’ll have to file quarterly tax payments of your estimated federal income taxes. Some state taxing authorities may get involved as well by taxing LLC income directly. On the other hand, some charge fees for LLCs.
While you may be able to deduct the cost of forming an LLC and capital expenditures such as materials and equipment that are used by the business, there are some limits to what you can do when it comes to deducting other expenses. Specifically, you may not be able to deduct benefits like health and life insurance, which you might be able to do if you organize as a C corporation. If your LLC provides you with these types of benefits, you may have to pay taxes on them.
Tax Considerations for an LLC
When deciding how you want your LLC to be taxed, it’s important to consider all of your possibilities to make an informed decision. The right tax method for you might change based on what your biggest need is and how that need is treated for taxes. Here are the most important tax considerations when you form an LLC:
- Double Taxation: Some tax treatments allow for your business to be taxed for income and then that same money is taxed again when it passes to the business owner. This may or may not be a dealbreaker for you depending on what your other needs are but it is something that should be considered.
- Tax Rates: Depending on your tax treatment for your LLC, your tax rate might fluctuate. For example, if your business is considered to be a disregarded entity then those tax obligations will fall to you. This can drive your personal tax rate up. However, if you’re taxed as a corporation then the business itself must file a tax return and your personal taxes won’t be impacted in terms of your rate with anything other than your ordinary income.
- Capital Expenditures: With an LLC, there is a possibility of you being able to claim a deduction on your capital expenditures for purchases of equipment that the business uses.
- Business Expense Deductions: Some tax treatments will benefit you more than others when it comes to deducting business expenses. The type of business expenses that you pay the most will depend on which tax treatment is the best. For example, a C Corporation is typically more beneficial for medical expenses.
Bottom Line
Limited liability corporations offer business owners flexibility in choosing how their business income will be taxed at the federal level. You can also set them up at lower costs and with less hassle than a C corporation, for instance. Furthermore, they still give proprietors some protection against liability claims as corporations do. If you’re considering how to organize your business, an LLC may be one of the options to consider.
Tips to Maximize Your Business’ Potential
- Enlist the help of a professional if you need help managing the finances of your small business. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Where you bank with your business is often overlooked, but paying attention to this detail can boost your finances significantly. Check out our list banks that small business owners may want to consider to take advantage of these opportunities.
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