Registering your business as a limited liability company (LLC) is a relatively simple and inexpensive process. Along with protecting you from personal liability, registering your business as an LLC can help it gain credibility and establish financial independence. LLC tax benefits are another significant part of the decision to set up and register your business as an LLC.
It’s important to understand that the tax advantages of LLCs depend on how the LLC members elect to pay taxes. What is most advantageous will not be the same for every LLC. There are a few different tax options available for LLCs.
How Is an LLC Taxed?
The default federal and state tax classification for an LLC is that of a “disregarded” or “pass-through” entity. This designation means the LLC is not taxed as its own business entity. Instead, each member (or shareholder) is responsible for reporting and paying personal income taxes on their share of the business’ profits (or losses). Each member may also have to pay federal self-employment taxes, including individual and employer contributions for Medicare and Social Security.
Regarding single-member LLCs, they simply include the profits and losses on their individual income tax return. The LLC default tax status of multi-member LLCs is essentially the same as a partnership: each member reports their share of profit and loss in a schedule attached to their individual income tax returns.
The Internal Revenue Service (IRS) also allows an LLC to elect S-Corp federal tax status. This allows the LLC to continue to be treated as a pass-through entity while reducing its members’ self-employment (FICA) tax obligations. The LLC does not pay taxes as a business entity to either federal or state agencies, while the individual members enjoy the LLC tax benefits directly. Larger and more profitable LLCs may use this designation to reduce their members’ income tax burdens significantly.
Are There Different Tax Brackets for LLCs?
As a sole proprietorship, partnership, or S-Corp, an LLC does not pay taxes as a separate corporate entity. Therefore, it does not have its own tax bracket, and no real LLC tax benefits or incentives are available to the LLC itself.
Because of the pass-through nature of the LLC, tax rates for its members or shareholders will vary. Each reports their share of pass-through income and losses from the LLC on their personal tax return. State and local agencies then assess tax at each member’s individual income tax rate.
However, a provision in the 2017 Tax Cuts and Jobs Act allows many owners of pass-through entities to deduct up to 20 percent of their net business income from their income taxes. Eligible LLC members/owners may be entitled to take the Qualified Business Income (QBI) Deduction on their individual returns, which can affect the individual tax brackets of the LLC’s members. Since the QBI eligibility requirements can be complicated, individuals who wish to explore this option should consult with a tax professional.
Other Options for Your LLC: Tax Benefits of C-Corp Status
Many businesses choose to organize as an LLC rather than a corporation (also called a C-Corp). LLCs are easier and cheaper to set up and manage. They do not have to comply with many of the recordkeeping requirements and other formalities required to maintain a corporation.
The LLC default tax status is often better for a business than being taxed as a C-Corp. One of the drawbacks of a C-Corp is “double taxation.” This refers to a situation where the corporate entity pays taxes on its earnings and then distributes those earnings as corporate dividends; shareholders then pay taxes individually on those earnings. By contrast, the profits of an LLC are not taxed at a corporate level before they “pass through” to the shareholders directly.
However, a C-Corp can take advantage of many tax reduction strategies not available to an LLC. Tax benefits of C-Corp status include the ability to classify members as employees, deducting their wages from the company’s profits. Doing so can reduce the company’s overall tax obligation while benefiting the members individually.
The IRS allows certain LLCs to elect to be treated as C-Corps for tax purposes, even if they are not registered as C-Corp business entities. To make this election, LLCs must meet specific criteria and properly certify the request with the IRS. C-Corp tax classification for LLCs significantly increases the complexity of their operations and financial management. However, in some instances it can also significantly increase their profitability.
Starting an LLC? Learn More
If you’re starting a business and considering an LLC, tax benefits are just one of many things to evaluate. Learn more about the options available and find helpful resources for all your small business tax questions.