Entrepreneurs can choose from various business structures when setting up a venture in the US, including sole proprietorships, general partnerships, corporations, and limited liability companies (LLCs). One of the most critical considerations is taxation—and under IRS tax rules, an LLC can offer more flexibility than some other structures.
Here are the specifics of LLC taxation and the benefits and drawbacks of being an LLC owner.
What is an LLC?
A limited liability company is a business structure best known for combining the liability protection of a traditional corporation with the simplicity and flexibility of partnerships and sole proprietorships. Unlike the latter, an LLC is considered a separate legal entity from its owners (known as “members”). This provides liability protection, shielding owners’ personal assets from risks or financial claims associated with bankruptcy or litigation.
How are LLCs taxed?
Among the most notable features of the LLC is tax treatment. LLCs are taxed like sole proprietorships or partnerships and are considered pass-through entities by tax authorities. They don’t pay corporate income taxes on any profits, and instead, they pass profits through to the owners, who then pay tax on these earnings based on their personal income tax rate.
LLC taxation is distinct from that of traditional corporations, which pay tax on corporate income at federal and, where applicable, state and city rates. Tax is then levied on any income distributed to owners, who pay based on their individual tax brackets. This two-step process is commonly known as double taxation.
How is an LLC taxed when classified as a partnership?
When an LLC has at least two members, it’s classified as a partnership by default. Income generated by an LLC in partnership form is passed through to its members, who pay tax based on their personal rates.
How is an LLC taxed when classified as an S corp?
S corps are another type of pass-through entity, which are not subject to federal corporate income tax. Some cities and states levy a corporate income tax on S corps, but it is usually lower than the federal corporate income tax rate.
LLCs can elect to be taxed as an S corporation (S corp) by filing Internal Revenue Service Form 2553. Once the IRS approves the election, the LLC pays members two ways: through salary and distributions. Salary, also known as owner-employee wages, is subject to FICA payroll taxes (15.3%). The LLC pays half of these taxes (7.65%), and the owner-employee pays the other half. Although salaries are subject to both payroll and personal income taxes, any remaining income can be distributed to members, bypassing payroll taxes and the self-employment tax, which is the same as the 15.3% FICA tax.
4 tax benefits of an LLC
- Tax flexibility in allocating income and losses
- Avoiding double taxation
- QBI deductions
- Business tax deductions
Running your small business as an LLC offers an array of tax benefits, though complex and multilayered rules apply. Some of the more notable tax advantages include:
1. Tax flexibility in allocating income and losses
LLCs enjoy wide latitude in making internal adjustments to income and losses. An LLC may allocate certain income and/or losses to specific members under its operating agreement—a legal contract between owners specifying how the business operates and determining internal accountability and benefits. This allocation could, for example, lower a member’s tax bill by letting them use an LLC’s losses to offset other income, either in the current tax year or future years.
2. Avoiding double taxation
LLCs can avoid double taxation by operating as a pass-through entity instead of as a corporation. In effect, the LLC’s profits and losses are passed through to members, who report these on their personal tax returns. The LLC itself doesn’t pay federal income taxes on profits; only members do. In a traditional corporation, the business’s earnings would be taxed once at the corporate level and again as personal income once funds are distributed to owners or shareholders.
3. QBI deductions
The qualified business income deduction (QBI) is an IRS tax deduction available to small business owners, including LLC owners. The QBI deduction allows LLC members an additional deduction on top of normal business expenses on income tax returns. The QBI lets members claim as much as 20% of business income as a deduction—however, this policy is set to end in 2025.
4. Business tax deductions
LLCs, like a number of other businesses types, may deduct various expenses on tax returns, including:
- Health insurance premiums for employed members and family
- Disability insurance for employees, including members
- Office supplies, internet, and phone services
- Charitable donations (up to 10% of an LLC’s taxable income)
- Home office-related expenses;
- Business vehicle expenses and mileage
LLC tax benefits FAQ
What can you write off on taxes for LLCs?
LLCs may write off normal business expenses, including office supplies, insurance premiums, home office maintenance costs, and sometimes even charitable donations.
Do LLCs get tax breaks?
LLCs are pass-through entities, meaning they do not pay corporate income tax. Rather, they pass through any income to the owners, who then pay tax at their personal rate. This avoids the double taxation of traditional corporations, which pay tax once on corporate income, while owners or shareholders also pay tax on any distributions of corporate income or dividends. Another break applies to small LLCs, which are entitled to the QBI, a tax deduction equal to as much as 20% of business income. This break expires in 2025.
How does an LLC affect my personal taxes?
Operating your business as an LLC may affect your personal taxes in several ways:
- Write-offs and tax breaks. Operating your business as an LLC offers certain tax write-offs and breaks that could lower your personal tax burden.
- S corp election. If your LLC is taxed as a pass-through S corp, distributions to owners are not subject to payroll or the 15.3% self-employment tax.
How is pass-through taxation different from corporate taxation?
Pass-through taxation differs from corporate taxation because companies subject to pass-through designation don’t pay corporate income tax. Instead, they distribute income to owners, who pay at their personal tax rates. Meanwhile, corporations pay corporate federal income tax and—where applicable—state corporate income tax on earnings. Owners or shareholders who receive distributions or dividends from these earnings also pay personal income tax on this income based on their individual tax bracket. This is widely known as double taxation.