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 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 learn all you need to know about the tax benefits of an LLC.
LLCs are pass-through entities, meaning income passes through to the member or members who report the income.
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.
This differs from corporations which are taxed on the income of the corporation. Dividends paid to shareholders are also taxed, which is double taxation.
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 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. Again, 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, with S-Corp status, which also offers pass-through taxation, self-employment taxes do not apply to members, 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 are more significant than those additional expenses.
When you start an LLC, your startup costs are generally deductible, as are operating expenses like utilities, phone bills, rent, business mileage, and business meals.
A franchise tax is not a tax on a franchise business. It’s a tax that some states charge as the cost of doing business in that state. Some states only charge a franchise tax on corporations.
LLC Tax Disadvantages
An LLC does have a few tax disadvantages, as outlined below.
As mentioned, LLC members are subject to self-employment taxes in addition to the income tax on the profits of the LLC. Self-employment taxes go toward Social Security and Medicare.
Pay taxes on all business income
As an LLC member, you must pay taxes on all the profits of the LLC, even if they were not distributed to you. So, if you’re the sole member of the LLC and it makes $100,000 in profits, but you only distributed $50,000 to yourself, you have to pay income taxes on the entire $100,000.
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.
In an LLC, the members do not have to answer to anyone. 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 legally 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, owners can specify in the operating agreement any profit-sharing plan they choose. One member can take a 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 day-to-day operations.
If you have a sole proprietorship, your name is the legal business name. An LLC allows you to choose your business name, lending more legitimacy.
Tax advantages are one of many benefits offered by an LLC and one of the main reasons entrepreneurs choose to operate as an LLC rather than a sole proprietorship or corporation.
Consult an attorney and tax advisor if you’re unsure if an LLC suits you. It’s crucial to get your business off on the right foot by making the choice that will give you the best chance of success.