Figuring out your business form might seem overwhelming because there are so many types of businesses to start. One good option is a limited liability company (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.
Single-Member LLC. The default tax status of an LLC with one owner (called a member) to be taxed as a disregarded entity. This means the LLC owner usually files a Schedule C to report business income, in the same way as a sole proprietorship. The Schedule C net income is included with other income of the owner on Form 1040/1040-SR.
The default tax status of an LLC with more than one owner (member) is to be taxed as a partnership. 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.
Tax Advantages of the LLC
Avoids Double Taxation
One advantage of the LLC over corporations is that the LLC owners aren't subject to double taxation. A corporation pays corporate taxes, and the owners of the corporation are shareholders who pay taxes on the dividends they receive. Corporations are subject to double taxation, meaning that the business is taxed on its income and the shareholders are taxed on dividends.
May Avoid Corporate Franchise Tax
In some states, corporations must pay state corporate franchise taxes, but some states do not require LLCs to pay this tax. This varies greatly from state to state, so check with your state tax department to see its requirements.
Tax Deductions for Small Business Owners
A new deduction is available to LLC owners and other small business owners that is not available to corporate shareholders. It's called a Qualified Business Income (QBI) deduction, and it allows LLC owners to get a 20% deduction from their business net income, in addition to the normal business expense deductions.
LLCs also have the option to be taxed as a corporation or an S corporation, by making an election with the IRS, to get the best tax advantage. The business is still operated as an LLC but pays taxes as a corporation or S corporation.
Tax Disadvantages of the LLC
Tax Owed on Profits
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.
Self-Employment Taxes Owed
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.