Startup owners usually opt for a limited liability company (LLC) because they know it offers them both a more favorable tax structure and personal liability protection. The process of getting this protection is easy and free of burdensome red tape.
Surprisingly, many startup owners are not aware that once they decide on an LLC, they are offered more tax flexibility through various LLC options. Making an informed choice of an LLC structure can improve LLC taxation, something vital for every new business.
Most common LLC tax classification for businesses
Single-member LLCs can choose to be taxed as a sole proprietorship, C corporation, or S corporation. Multiple-member LLCs can be taxed as a partnership, C corporation, or S corporation. However, most LLC owners prefer to be taxed as sole proprietorships or partnerships.
“Disregarded entity” in a single-member LLC
If a single-member LLC opts to be taxed as a sole proprietorship, then it falls into a “pass-through” taxation category. This means the owner of the LLC reports the business income or loss on their personal tax form, and the business does not file any tax forms.
Owners that engage in business or trade can take a distribution from LLCs profits and they pay self-employment taxes. That amount is not taxed as an income because it has already been taxed as part of the LLC’s total profits. LLCs formed for passive activities, like real estate investments, don’t pay self-employment tax on profits.
Even though the LLC is treated as a “disregarded entity” for taxation purposes, it still offers personal liability protection. Another benefit is that the business can also deduct business expenses.
Partnership taxation of a multiple-member LLC
Typically, LLCs with two or more partners are taxed as a partnership. Once again, the LLC does not pay income tax to the IRS. The profits are distributed to the partners according to the partnership operating agreement, and each member pays taxes individually according to this.
Owners within a multi-member LLC can take a distribution from their share of the profits. This amount is taxed with self-employment taxes, but not as an income.
Opting to be taxed as a corporation
Both single and multi-member LLCs can opt to be treated as corporations for tax purposes. C corporations and S corporations are not appropriate for all types of businesses, but some prefer to choose any of the two types of corporations for tax or business purposes.
Understanding C corporation taxation
An LLC that has opted to be taxed as a C corp pays the corporate tax rate on its profits. The profits can be distributed to the LLC owners in the form of dividends, but in what is known as double taxation, these are taxed at the current dividend rate.
Even though the LLC’s profits are not subject to self-employment taxes, the C corp must pay payroll taxes for any LLC members earning a wage from the business. If the LLC decides to keep the profits in the company and not distribute them, the company is taxed on the profits. The owners pay no personal tax on these profits.
Understanding S corporation taxation
In an S corp, the company profits are not subject to corporate income tax nor self-employment tax. Each owner is taxed on their share of the company’s profits. Any of the LLC owners that work in the business must be paid a reasonable wage and the company pays the appropriate payroll taxes.
One of the main advantages of S corps is that they aren’t double-taxed and the owners save on employment taxes. The remaining money can be distributed as dividends to active shareholders, lowering the total taxes owed by the business owners.
S corps have some disadvantages. There is a limit on the number of shareholders an LLC can have and all owners must be U.S. residents or permanent residents. Additionally, because of their complicated tax designation, they may invite closer scrutiny from the IRS. It is imperative that the company abides by all IRS regulations and avoids accounting or filing mistakes; these can cost the LLC its S corp status.
LLCs can choose a tax structure that benefits their members best. By default, they benefit from pass-through taxation, but if the business wants to avoid self-employment tax, attract investors, and benefit from potential tax deductions, then being taxed as a corporation is also a viable option.