The Tax Advantages and Disadvantages of an LLC

Business owner talking to accountant on the phone about his business taxes.

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Figuring out your business form might seem overwhelming because there are so many types of businesses to start. One good option is an LLC, which has some of the control benefits of the sole proprietorship or partnership and some of the tax and liability benefits of a corporation. But there are also reasons not to form an LLC. 

What Is an LLC? 

A limited liability company is a newer legal form of business than the older corporation or partnership forms. An LLC is formed through the state in which the company is doing business by filing Articles of Organization and paying a fee. 

How Does an LLC Pay Income Taxes?

Because an LLC is fairly new, the IRS does not have a specific tax category for this business type, so they use the tax categories of other business types. 

The default tax status of an LLC with one owner (called a member) to be taxed as a sole proprietorship. The default tax status of an LLC with more than one owner (member) is to be taxed as a partnership.

In either case, the LLC doesn't pay taxes directly, but the business net income is taxed through the personal tax return of the owner or owners — as a sole proprietorship, for a one-member LLC or as a partnership for a multiple-member LLC. This is called "pass-through taxation."

For a sole proprietor/single-member LLC, the tax for the business is calculated using Schedule C as part of the tax return, then the business net income is added to the owner's other income on the tax return. For a partner/multiple-member LLC owner, the partnership tax return is prepared on Form 1065, and the individual owner's part of the tax is calculated on Schedule K-1, and it's included in the owner's individual tax return.

A corporation pays corporate taxes, and the owners of the corporation are considered to be employees if they work in the business (otherwise, they are considered shareholders). There are tax advantages and disadvantages of the LLC vs. a corporation that should be considered by business owners. 

Tax Advantages of the LLC

The tax rate for an LLC depends on the total income of the owner. At higher levels of net income, the LLC may be paying taxes at a lower tax rate than a corporation. For example, the corporate tax rate for $75,000 in taxable income is 34%, while the personal tax rate for this same taxable income is 25%. (Other factors and other income may be included in the personal income of a business owner.)

Corporate owners may be subject to double taxation, while an LLC owner is not. Corporate owners have double taxation because the entity pays taxes on corporate net income, and the corporate owners must pay tax on any dividend income they receive. 

In some states, corporations must pay state corporate franchise taxes, but some states do not require LLC's to pay this tax. (This varies greatly state to state, so check with your state tax department to see its requirements.)

Tax Disadvantages of the LLC

LLC members must pay taxes on their distributive share of the profit of the company, even if they have not received a distribution of those profits. Owners of a corporation do not pay taxes on profits unless they are distributed, usually in the form of dividends. 

Some states exempt corporations from property tax, but not other entities, including LLCs. Also, LLC owners take a big hit with self-employment taxes (Social Security/Medicare). While corporate owners who serve as employees only pay half of the self-employment tax amount on their salaries and the company pays the other half, the LLC owner pays both employer and employee portions

Deciding for You and Your Business

Every company's tax situation is different, and tax situations change over time as a company grows and becomes more profitable. The purpose of this article is to give you general information about this subject so you can discuss it with your tax advisor. Be sure to have this discussion so that you can be well informed before you make any decisions on the structure of your business or changing your business structure.