Finding out your business's shape can seem like a chore, as there are many types of businesses to start. A good option is a limited liability company (LLC), which has some of the advantages of controlling a single corporation or partnership and some of the tax and liability advantages of a corporation. But there are also reasons why you shouldn't form an LLC.
What is an LLC?
A limited liability company is a new legal form of business compared to older partnerships or corporations. An LLC is formed in the state where the business operates by filing Articles of Organization and paying a fee.
How does an LLC pay income tax?
The Internal Revenue Service (IRS) does not have a specific tax category for this type of business, so it uses tax categories for other business types.
Single Member LLC: A default tax status of an LLC with a sole owner (named member) should be taxed as a disregarded entity. This means that the LLC owner usually files a Schedule C to report business income in the same way as a sole proprietor. Net income from Schedule C is included with other income of the owner on Form 1040/1040-SR.
The standard tax status with multiple owners (members) is to pay taxes as a partnership. For an owner/partner of a multi-member LLC, the partnership income tax return is done on Form 1065. The individual owner's tax rate is calculated in Schedule K-1 and included in the individual owner's tax return.
LLC Tax Benefits
Circumvents double taxation
An advantage of LLCs over corporations is that owners of LLCs are not subject to double taxation. A company pays corporate taxes, and the company owners are shareholders who pay taxes on the dividends they receive. Corporations are subjected to double taxation, which means the corporation pays taxes on its income, and shareholders pay taxes on dividends.
You can avoid the business franchise tax.
In some states, businesses must pay state taxes on corporate franchises, but some states do not require LLCs to pay this tax. It varies hugely from state to state, so check the state tax office requirements or talk to a tax advisor.
Tax deductions for small business owners
A new deduction is available for LLC owners and other small business owners not available to corporate shareholders. This is called a qualified business income deduction (QBI) and allows LLC owners to deduct 20% of their net business income in addition to the deductions for normal business expenses.
LLCs also can pay taxes as a corporation or S corporation by making an election with the IRS to get the best tax benefit. The company still operates as an LLC but pays taxes as a corporation or S corps.
LLC's Tax Disadvantages
Income tax due
Members of the LLC must pay taxes on their share of the company's profits, even if they are yet to receive a distribution of those profits. Owners don't pay income tax unless it is distributed, normally in the form of dividends.
Some states excuse corporations from property tax, unlike other entities, including LLCs.
Self-employment taxes owed
LLC owners are also severely affected by Social Security/Medicare self-employment taxes. While the owners of the businesses who act as employees pay only half of the self-employment tax amount on their salary and the business pays the other half, the LLC owner pays the contributions as both an employer and an employee.
Bottom Line
Every business's tax situation is different, and the tax situation changes over time as the business grows and becomes more profitable. The aim of this article is to provide general information on this topic so that you can discuss it with your tax advisor. Make sure you have this conversation to be well informed before making decisions about structuring your business or changing your business structure.
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Don Bell Law