How Is an LLC Taxed?

When starting a new business, one of the first decisions is the type of business entity to form. Many entrepreneurs choose a limited liability company (LLC) because of its many benefits. An LLC provides personal liability protection, for example, so that your assets are not at risk if your business is sued or cannot pay its debts. 

Other benefits of an LLC are its tax advantages and flexibility. In this handy guide, you’ll find out everything you need to know about how LLCs are taxed.

How LLCs Are Taxed

The LLC itself is not taxed. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership. 

However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.

C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But keep in mind that C-Corp shareholders – who are members in the case of an LLC – must also pay taxes on their distributions. This is called double taxation. 

However, members are subject to self-employment tax in an LLC that is taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply. 

Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status. 

With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses. 

Other Advantages of an LLC

Let’s discuss the other specific benefits of an LLC.

1. Simplicity of Administration

LLCs are easier and less expensive to form than a corporation. Unlike corporations, LLCs are not required to have a board of directors or hold annual meetings. LLCs do, in most states, have to file annual reports. Corporations are more complicated.

2. Control

In an LLC, members do not have to answer to anyone. Instead, they fully control the company and can structure the management in any way they choose. A sole proprietorship is the only type of business entity that offers more control. 

In a corporation, on the other hand, managers answer to the board of directors, which has overriding decision-making power. 

3. Limited Personal Liability

In LLCs and corporations, owners are considered separate entities from the business, so both structures offer limited personal liability protection. However, in a few instances, owners do have personal liability. For example, if an owner guarantees a bank loan, which is expected, they are personally liable for that debt. 

In a sole proprietorship, on the other hand, the business owner and the business are considered the same, so the owner is personally responsible for all obligations of the business.

4. Profit Sharing Flexibility

Most businesses, no matter the entity type, split profits based on owners’ capital contributions. Corporations pay dividends based on the ownership percentages of shareholders. 

In an LLC, on the other hand, members can specify in the operating agreement any profit-sharing plan they choose. One member can take a percentage share of profits greater than their percentage of ownership interest, while other owners take less. This may be decided based on the fact that one member is more involved in operations than others.  

5. Credibility

If you have a sole proprietorship, your name is the business’s legal name. An LLC allows you to choose your business name, lending more legitimacy. 

In Closing

Tax flexibility is one of many benefits offered by an LLC and one of the main reasons entrepreneurs prefer to create an LLC rather than a sole proprietorship or corporation. 

If you’re unsure whether an LLC is right for you, consult an attorney or tax advisor. Choosing the option that gives your business the best chance of success is important.