Limited liability companies (LLCs) are popular business structures that provide owners with both liability protection and tax benefits. Unlike sole proprietorships and partnerships, LLC owners are not personally liable for business debts and liabilities. And unlike corporations, LLCs don’t require formalities like annual meetings and board of directors.
When it comes to taxes, LLCs allow owners to take advantage of the beneficial features of partnerships and corporations. Here are some of the key potential tax benefits of LLCs:
Pass-Through Taxation
One of the biggest advantages of an LLC is that it is taxed as a pass-through entity by default. This means that instead of paying taxes at the corporate level, an LLC’s profits and losses pass through to the owners’ personal tax returns.
LLC owners report their share of business income or loss on their personal tax returns. The LLC itself does not pay federal income tax. Pass-through taxation avoids the double taxation on corporate income that C corporations are subject to.
How Pass-Through Taxation Works
Here is a simple example to illustrate pass-through taxation for an LLC:
- XYZ LLC has $100,000 of net income for the tax year.
- The LLC has two equal owners, John and Jane.
- XYZ LLC files an informational return but does not pay entity-level taxes.
- The $100,000 of income passes through to John and Jane, who each report $50,000 of business income on their personal tax returns.
- John and Jane pay individual income taxes on their $50,000 share of LLC income.
This pass-through treatment results in no federal tax paid at the LLC level. The owners pay personal income tax once on their share of LLC income. This contrasts with C corporations, which face corporate income tax and shareholder taxes on dividends.
Choice of Entity Tax Status
An advantage of the LLC structure is flexibility in choosing how you want the entity to be taxed. LLCs can choose between being taxed as:
- A partnership
- A sole proprietorship (if single-member)
- A C corporation
- An S corporation
By default, a multi-member LLC is taxed as a partnership and a single-member LLC is taxed as a sole proprietorship. But LLCs can elect to be taxed as a C corporation or an S corporation by filing Form 8832 with the IRS.
S Corporation Tax Treatment
Many LLCs elect to be taxed as S corporations. This provides liability protection while gaining key S corporation tax benefits, such as:
- Avoiding self-employment taxes: S corporation owners only pay self-employment taxes on their salaries.
- Allowing more flexibility in owner compensation compared to partnerships.
- Pass-through taxation similar to partnerships.
Electing S corporation status can be very beneficial but does come with eligibility requirements. For example, S corporations can only have one class of stock and up to 100 shareholders. Overall, the flexibility to choose corporate taxation is a notable benefit of LLCs.
Deductible Business Expenses
As pass-through entities, LLCs allow owners to deduct eligible business expenses. These pass-through deductions reduce the owner’s taxable income from the LLC.
Common deductible LLC expenses include:
- Start-up costs like legal fees and licenses
- Salaries, wages, and benefits
- Employee health insurance
- Retirement plan contributions
- Business travel and vehicle use
- Rent, utilities, supplies
- Depreciation on assets
- Advertising, marketing, and promotion
- Accounting, tax prep, and professional fees
- Interest paid on business loans
- Repairs and maintenance
Business deductions directly reduce the LLC owners’ tax liability by lowering their net income from the business. Tracking allowable business expenses throughout the year is crucial for maximizing deductions.
Business Expense Example
Here is an example of how LLC expenses can generate tax deductions:
- Gross income: $500,000
- Expenses:
- Salaries and benefits: $80,000
- Office rent: $24,000
- Supplies: $5,000
- Utilities: $8,000
- Equipment depreciation: $10,000
- Total expenses: $127,000
- Taxable income: $500,000 – $127,000 = $373,000
This LLC was able to deduct $127,000 in common business expenses, reducing taxable income by over 25%. Tracking expenses boosts write-offs.
Tax Filing and Deadlines
How an LLC files taxes depends on how it elects to be taxed:
| Entity | Tax Return | Due Date |
|---|---|---|
| Partnership | Form 1065 | March 15 |
| S corporation | Form 1120S | March 15 |
| C corporation | Form 1120 | April 15 |
| Sole proprietorship | Schedule C (Form 1040) | April 15 |
In addition to the entity return, LLC owners must file their personal tax return (Form 1040) by April 15, reporting their share of LLC income or loss. Estimated quarterly tax payments may also be required to avoid underpayment penalties.
State Taxes
In addition to federal taxes, LLCs may be subject to state income taxes in the states where they do business or have a physical presence. Rules vary by state. Some key factors include:
- Pass-through taxation – Most states follow federal rules and tax LLCs as pass-through entities.
- Filing requirements – Even if no state income tax is due, many states require LLCs to file informational returns and pay annual fees.
- Nexus – Having an office, employees, or conducting certain levels of business in a state can create tax filing responsibilities and liabilities.
- Double taxation – Some states impose entity-level taxes on LLCs in addition to pass-through owner taxes.
Complying with state tax rules for LLCs can be complex, especially in multiple states. Professional guidance is recommended to avoid costly mistakes and penalties.
Self-Employment Taxes
LLC owners who provide services and actively manage the business are subject to self-employment (SE) tax on their share of LLC profit. The current SE tax rate is 15.3%, with 12.4% going to Social Security and 2.9% to Medicare.
The first $142,800 of combined wages and SE income in 2023 is subject to Social Security tax. The 2.9% Medicare tax on SE income has no income limit.
Some strategies like paying a reasonable salary to owner-employees can reduce SE tax liability. But active LLC owners generally pay much more in SE taxes than S corporation shareholders or limited partners.
Self-Employment Tax Example
Here is an example of how SE tax is calculated for an LLC owner:
- LLC profit: $200,000
- Owner’s share: 50% = $100,000
- SE tax rate: 15.3%
- SE tax due: 15.3% x $100,000 = $15,300
This LLC owner would pay over $15,000 in SE taxes on their $100,000 share of LLC income. SE taxes are in addition to regular income taxes.
Employment Taxes
If an LLC has employees, it must pay federal and state employment taxes. These include:
- Income tax withholding
- FICA taxes (Social Security and Medicare)
- Federal unemployment tax (FUTA)
- State unemployment tax (SUTA)
LLCs must withhold taxes from employee wages, match FICA taxes, deposit funds with tax agencies, file payroll tax returns (Form 941, 940), and issue W-2 forms to employees.
Failure to handle payroll taxes properly can lead to large penalties. Many LLCs work with payroll providers or CPAs to ensure compliance with employment tax rules.
New Employer Registration
Before hiring, LLCs must register with federal and state tax agencies to obtain an EIN and tax accounts. Key registration steps include:
- Obtain an Employer Identification Number (EIN) from the IRS
- Register with your state tax agency for income tax withholding
- Set up accounts for payroll taxes with the IRS and your state
- Determine your state unemployment insurance rate and obligations
Completing new employer registration is critical for handling payroll taxes correctly when hiring staff.
Tax Implications of LLC Distributions
LLCs classified as partnerships for tax purposes have flexibility in making cash distributions to owners. Distributions are typically not taxable up to the extent of the owner’s basis in the LLC.
An LLC owner’s basis starts with their capital contributions to the entity. It increases with their share of LLC profits. Basis decreases by the amount of distributions received and allocable losses.
For example, say an LLC member contributed $10,000 cash, has $5,000 of undistributed profit, and has a $12,000 basis. They could receive a $12,000 distribution tax-free. Amounts exceeding their basis would be taxable capital gains.
These partnership tax rules provide more flexibility than C corporations, where dividends are taxable. Careful basis tracking and tax planning should be used to minimize taxes on LLC distributions.
Losses and Deductions
LLC losses and deductions pass through and flow to the owners’ personal tax returns, reducing their taxable income. This provides tax benefits to offset both passive and earned income.
However, passive loss deduction rules limit using LLC losses to offset other income. Passive losses can only offset passive income. Excess losses are carried forward to use when the activity generates income.
Materially participating in the LLC can allow greater use of losses against other income like wages and investments. Over 100 partner hours and over 500 total hours in the LLC activity during the year can qualify as material participation.
At-Risk Limitations
The at-risk rules also limit using LLC losses to the amount each taxpayer has economically “at risk” in the activity. Losses can’t exceed capital contributions plus recourse business debt.
Nonrecourse debt generally does not increase a taxpayer’s at-risk amount. For real estate LLCs, nonrecourse debt can increase the at-risk limit only to the extent it does not exceed the property’s basis.
Following the complex passive activity and at-risk rules allows maximizing the tax benefits of LLC losses for the owners.
Sales of LLC Interests
When an LLC owner sells their interest in the entity, tax treatment depends on whether the LLC elected to be taxed as a corporation or partnership.
For LLCs taxed as partnerships, selling an interest is generally treated as selling a capital asset. The seller pays capital gains taxes on the difference between the sales price and their tax basis.
LLCs taxed as corporations follow corporate stock rules. Differences between the sales price and tax basis are taxed at capital gain rates for long-term holdings or ordinary rates for assets held one year or less.
LLCs provide more flexibility than corporations in ownership transfers. However, complex special rules can apply in transactions between co-owners.
LLC Equity Compensation
LLCs taxed as partnerships can provide equity compensation to owners and employees through “profits interests.” These provide a share of future LLC profits without immediate taxation.
The recipient only owes taxes after the interest begins yielding income allocations exceeding the value when originally awarded. At vesting, ordinary income tax applies to the liquidation value.
Profits interests allow LLCs to incentivize people while only paying taxes on actual income received. The tax rules are complex, requiring guidance from advisors to implement properly.
Conversion to a C Corporation
LLCs can elect to convert to C corporation status at any time by filing Form 8832. This may be beneficial to access corporate tax rates, structure ownership with preferred stock, or prepare for going public.
However, conversions can trigger built-in gains taxes and other costs. Appreciated property also becomes subject to double taxation at the corporate and shareholder levels.
A tax professional can help determine if conversion makes sense based on the LLC’s circumstances and goals. All tax implications should be fully considered.
Selling the Business
When selling an LLC’s entire business, the tax consequences depend on the entity’s structure:
- Partnership/sole proprietorship – Owners pay taxes on sale of individual assets.
- S corporation – Taxes apply at shareholder level on asset sales.
- C corporation – Taxable at both corporate and shareholder level.
The double taxation of C corporations makes the structure less appealing for selling a full LLC. However, the lower corporate rates can be beneficial in some scenarios.
Using a tax advisor to plan the sale through cost segregation and other strategies can maximize after-tax proceeds. Installment sales can also help defer taxes over time.
Liquidating Distributions
Owners who receive liquidating distributions from an LLC classified as a partnership do not owe taxes immediately provided basis rules are followed properly. Corporate structures result in more complex tax implications on liquidations.
Multi-member LLCs terminating within five years of formation could be subject to harsh partnership taxation rules. Tax professionals can guide LLC owners through the most tax-efficient exit strategies.
Conclusion
LLCs provide owners with a great combination of limited liability protection, pass-through taxation, and flexibility to structure the entity for optimal tax treatment. While taxes should not drive the overall business structure decision, understanding the potential tax benefits of LLCs is important.
Key tax advantages LLCs offer include pass-through taxation, deductible expenses, flexible distribution treatment, and the ability to select corporate taxation. Maximizing these benefits requires tracking basis, following complex rules for losses and sales, and working with qualified tax professionals.
LLCs allow optimizing taxes at both the entity and individual owner levels. With the right expertise and planning, LLCs can yield substantial tax savings versus other structures like standard C corporations.