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4 LLC Tax Advantages and Classifications For Your Business

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The foundation of a successful business is making the right decision at the right time. One of the foundational choices that an entrepreneur has to make is deciding how to register their business. They can choose between sole proprietorships, general partnerships, corporations, and limited liability companies (LLCs). Business owners figuring out how to manage their finances should note that due to the tax advantages of an LLC, it is often the most popular choice

An LLC is a legal entity that allows people to start and operate a business while enjoying certain advantages. One of the main reasons people choose to register their companies as an LLC is that, true to its name, it provides limited liability protection. This means the owners or members are not personally responsible for the company’s debts and liabilities. The member’s personal assets are usually not at risk if the business faces financial difficulties or legal issues. Hence, they are protected from bankruptcy and litigation. 

Yet, there is another significant advantage of setting up an LLC. Its unique taxation system has several benefits for business owners as well. This blog explains how the government taxes LLCs and the LLC tax advantages so that you can make informed decisions for your business. 

How Is an LLC Taxed?

Tax considerations should be an essential factor when choosing an appropriate business structure. If you’re considering forming a limited liability company (LLC), knowing that the Internal Revenue Service (IRS) does not have a designated tax classification specifically for LLCs is helpful. Therefore, this allows you to choose the taxation avenue that best suits your business. 

An LLC can be taxed in four ways:

  • A sole proprietorship
  • A partnership
  • A C corporation (C corp)
  • An S corporation (S corp)

If you are the sole owner of your business, you can choose to be taxed as a sole proprietorship, partnership, or C corporation. However, if your LLC has multiple owners, the option to be taxed as a sole proprietorship is not available. You must select from the remaining three options: partnership, C corporation, or S corporation. 

Each path has its own tax considerations, and you can decide based on which one suits your LLC and its owners’ needs and objectives. It’s essential to understand the basics of the business taxation system so that you know what to do if you file your taxes wrong and can take appropriate action. 

How Does an LLC Pay Income Taxes?

In a traditional corporation not registered as an LLC,  the company pays taxes to the government that are calculated on its profits. These taxes are levied at the federal, state, and city levels. This is why entrepreneurs must compare and contrast taxation laws nationwide and find the best and worst states for business taxes before deciding where to register their business.

But that’s not all. If the owners receive profits from the business, they would also have to pay taxes on the income they receive based on their individual tax brackets. This is called “double taxation” because the same amount is being taxed two times – once at the corporate level and once at the individual level. 

However, the taxation of an LLC works differently

Paying Taxes As A Sole Proprietorship or Partnership

Under the sole proprietor or the partnership pathway, the LLC does not pay taxes on its profits to the government. The profits and losses of the LLC “pass-through” to the owners. This income is reported on the member’s individual tax returns. They then pay taxes based on their individual tax brackets. This way, the LLC members avoid the double taxation system, potentially increasing their profits, which is one of the leading tax advantages of an LLC. The owners pay their taxes using the IRS Form 1040 after preparing a profit-or-loss report on IRS Schedule C.

However, the owners still have the flexibility to file their taxes as a corporation if they so choose.

Paying Taxes as a Corporation 

Multiple shareholders in an LLC usually report their profit or loss using a Schedule E form if the LLC has completed an S-Corp election. Single-member and multi-member LLCs may file taxes as a C corporation using IRS Form 8832 or as an S corporation using IRS Form 2553.

How Do LLC Members Pay Their Taxes? 

It’s important to note that an LLC can pay its members in two different ways – through their salaries or distributions.

  1. Salary: The LLC can pay the owners a compensation called owner-employee wages. Part of this salary is subject to FICA payroll taxes, which amount to 15.3% of the salary. So, the company pays 50% of the payroll taxes, and the owner-employee pays the remaining half. 
  2. Distributions: After paying the necessary salary, any remaining income in the company’s account can be paid to the owners. However, these payments are not subjected to payroll taxes or self-employment taxes.

By paying a portion of their income as a salary and then distributing the remaining income, the owners of an LLC can potentially reduce the amount of income given as taxes, resulting in savings in the long run. 

LLC Tax Benefits 

Registering a business as a Limited Liability Company can provide several tax benefits that can help entrepreneurs and owners save money. Even though these advantages may vary based on the owner’s circumstances, their personal tax brackets, and the tax laws in different states, entrepreneurs should consult with their accountants to understand the specific tax benefits available under an LLC registration. A few of them are listed below. 

Tax Flexibility and Income Allocation

These companies have the freedom to distribute income and losses among their members. LLCs can personalize how profits and losses are divided based on their operating agreement. By facilitating this, the members can use their losses to offset other sources of income, which could lower the overall amount they need to pay in taxes. 

Avoiding Double Taxation

As mentioned earlier, LLC profits and losses “pass through” to the owners, who add them to their personal tax returns. This ensures that the company doesn’t pay federal income taxes on profits. Instead, only the members do. On the other hand, traditional corporations are taxed at the corporate level, after which their shareholders are taxed again on any income they may receive as profits from the business, as done in double taxation. 

Qualified Business Income (QBI) Deduction

Even though a QBI deduction or a Qualified Business Income deduction (QBI) may not be available after 2025, the benefits it provides to businesses till then are considerable. This deduction allows LLC owners to claim up to 20% of their business income as a deduction on top of their regular business expenses, reducing the overall tax burden for owners. 

Business Expense Deductions

Owners can take advantage of the deductions applied toward various LLC business expenses. How much can an LLC write off? The amount an LLC can save on taxes depends upon deductions that help lower the taxable income of the LLC and its members.

A few examples of these deductions include: 

  1. Health insurance premiums for the owner and their family.
  2. Disability insurance premiums cover their employees, including the owner.
  3. Office supplies like stationery, printer ink, and computer equipment
  4. Costs for internet services and phone lines.
  5. Charitable donations can be deducted from their tax returns. The deductible is generally limited to 10% of the LLC’s taxable income. 
  6. Home office deduction applies to owners who use a part of their home exclusively for business purposes. They can list expenses like rent, utilities, and maintenance.
  7. Business vehicle costs include mileage, fuel, insurance, and maintenance expenses. However, it’s vital to maintain detailed records to show that the vehicle was used only for business, not personal errands. 
  8. Startup and organizational costs like legal fees, filing fees, licenses, or permits.
  9. Education and training expenses, like workshops, conferences, and training courses, help improve the skills and knowledge of owners or employees.
  10. Retirement contributions like a Simplified Employee Pension (SEP) IRA plan for the owners and employees. 

Sum Up

Registering a business as a Limited Liability Company (LLC) can provide significant tax advantages and benefits. The unique taxation system of an LLC allows for flexibility and potential savings, making it a popular choice for many entrepreneurs. LLC tax advantages enable owners to optimize their tax liability and maximize profits by avoiding double taxation and using deductions effectively. 

By understanding LLC tax advantages, entrepreneurs and owners can make sound decisions that could help them effectively manage their finances while laying a solid foundation for business success.