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Updated on Monday, August 23, 2021
A limited liability company (LLC) is a type of business formation that allows owners to avoid being held personally liable for a company’s debt, and it provides those owners some flexibility for lowering their business tax burden. The most significant tax advantage of an LLC is that you’re able to pass earnings through the company untaxed. You still have to pay individual income taxes, and if a business is structured as an LLC, those earnings are taxed as individual income by the government.
Read on to learn the full tax benefits of an LLC, as well as the potential tax disadvantages.
Tax advantages of an LLC
Here’s a rundown of the myriad tax advantages of operating as an LLC:
One of the main reasons to structure your business as an LLC is so you can take advantage of pass-through business taxation. Instead of paying taxes twice on business revenue (first as business income and then as personal income), LLCs enable business owners to pass revenue through the business and report that income on their personal tax returns.
If your business is an LLC, it could be considered a “disregarded entity” by the IRS — a term that indicates that the IRS doesn’t levy taxes on the business itself. The pass-through tax loophole is a great way for owners of an LLC to reduce their tax burden.
Typically, both businesses and individuals are taxable entities; with pass-through taxation, the business is not considered a taxable entity and owners can avoid the corporate income tax.
While there may be some self-employment taxes for business owners, the savings from pass-through legislation are often enough of an incentive for LLCs to elect to be taxed as a sole proprietorship or partnership.
One tax benefit of an LLC is that it offers members some options on how they choose to pay their taxes. Once an LLC is formed, owners, who are called members, must determine which federal tax classification they’d prefer for their business-related income:
- Sole proprietorship: Single-member LLCs often choose to be taxed as a sole proprietorship, which enables them to pass income through the business. The LLC doesn’t have to pay any business taxes, as earnings and business-related deductions instead appear on the owner’s personal tax returns.
- Partnership: Multimember LLCs cannot be taxed as a sole proprietorship. But if they choose to be taxed as a partnership, they can report their business income and each member can pass through their share of earnings on their personal tax returns.
- S corporation: LLCs can elect to be taxed as an S corporation. They still don’t have to pay a business income tax, but members are taxed on their share of the profits. If a member works for the business, they must be paid a reasonable wage and deduct payroll taxes from that income.
- C corporation: An LLC can choose to pay the corporate income tax and be treated as a corporation by the IRS. If profits are distributed as dividends, those dividends are then taxed twice. LLCs that are taxed as C corporations must also pay taxes on wages paid to LLC members who work for the business.
For people who operate an LLC as a lone member, that business is considered separate from its owner unless it elects to be a corporation. That’s a significant advantage for most business owners, as they can pass profits through the business to themselves and pay taxes based on their own income without having to pay an additional business income tax to the IRS.
An LLC with multiple members is automatically classified as a partnership by the IRS for federal tax purposes unless its members affirmatively elect to be treated as a corporation. Businesses structured as an LLC partnership receive a 1065 partnership tax return form, but otherwise it works similarly to those run by a single member, as profits pass through the business and are allocated to the owners before taxes are levied on their net income.
There are some advantages to electing corporate taxation instead of using the pass-through income loophole to pay an LLC’s taxes as personal income. For example, the highest personal income tax rates are higher than the highest corporate tax rate. If someone’s LLC is extremely lucrative, they may pay a lower effective tax rate should they choose to be taxed as a corporation. LLCs that are taxed as corporations also don’t have to include all the profits from the business if they are not treated as pass-through entities.
Ultimately, business owners choose their LLC structure to limit their tax burden as much as possible. For most, that will mean treating the LLC as a pass-through entity and avoiding double taxation. But for some people with large businesses or unique circumstances, a tax expert may help determine that a corporate tax structure may be best for the LLC.
Business expense deductions
Like any other business, an LLC has the opportunity to write off certain expenses on their income taxes. If the LLC is considered a pass-through entity, those deductions can be claimed on a member’s personal income taxes. Usually these deductions are written off on a single year’s income tax return, but some larger expenses can be written off incrementally over the course of years — a process called depreciation.
Different businesses can write off vastly different types of expenses. A large retailer may have completely different write-offs than a comedian who operates his business as a sole proprietorship, for example. There are quite a few common types of deductions, though. LLCs can deduct expenses for renting office space, paying for insurance related to the business, payments to outside contractors and the cost of goods sold, among other things.
If an LLC chooses to be taxed as a corporation, they file an annual tax return on Form 1120 to report all income and business expense deductions. Partnerships require the LLC to report write-offs on Form 1065, and the write-offs are allocated proportionally like the income for members.
Tax disadvantages of an LLC
There are some tax disadvantages related to doing business as an LLC, though they’re often outweighed by the benefits. Avoiding double taxation on business and personal income with a pass-through LLC usually nets more in savings than it costs, but the downsides should be considered before starting a business as an LLC.
Self-employment taxes may diminish the tax savings from pass-through income if the member has to pay a significant amount in FICA (Federal Insurance Contributions Act) taxes. Those members may wind up paying more in taxes than an LLC that elects to be taxed as a corporation.
The current self-employment tax rate is 15.30% up to an annual threshold, and 2.90% above that threshold.
Profits must pass through
Another possible disadvantage of the pass-through LLC structure is that members have to immediately pass on their profits to their personal income tax.
Corporations can instead choose not to distribute all of its profits right away; since they don’t have to immediately recognize and distribute those profits, they may not always be taxed. Businesses that aren’t a pass-through LLC can retain their revenue and perhaps use some of it for capital investment, while pass-through businesses cannot.
Choosing how to structure your business
Before starting your business, it’s important to consider how you’ll structure it — whether you want to set up an LLC, and if you do, how you’d like to pay your taxes. Different types of businesses have different needs, but LLCs have some broad advantages, namely the pass-through tax loophole that enables owners to avoid paying taxes twice on business income.
Sometimes those advantages are outweighed by other considerations. For example, startups looking to raise funds quickly may choose to be taxed as a corporation, even if they are an LLC. In other cases, a partnership or sole proprietorship may make the most sense. A consultation with a tax professional or financial advisor before incorporating your business may help you determine the most sensible path to take.
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