LLC Pass Through Taxation Explained (How Does It Work?)
Navigating the complexities of LLC pass-through taxation can be a daunting task for many business owners.
As a qualified business expert with over a decade of experience, I have dedicated weeks to researching this topic in-depth to bring you the most accurate and actionable information.
This article is designed to demystify the intricacies of pass-through taxation for LLCs, offering you expert insights into how it affects your business and tax obligations.
Quick Summary
- Passthrough taxation is a system that allows LLC's income and losses to pass through to owners, avoiding federal taxes at the company level.
- By default, all LLCs are treated as disregarded entities for taxation purposes.
- LLC profits are not taxed at the company level but "pass-through" to owners' personal tax forms, a structure benefiting over 90% of LLCs by avoiding corporate taxes, according to the Tax Foundation.
- From my perspective, with passthrough taxation, owners and shareholders can receive their share of the LLC's profits as a return on investment (ROI) rather than dividends that are subject to double taxation.
What Is Pass-through Taxation?
Pass-through taxation is a type of taxation in which the taxpayer does not make payments directly to the government but instead pays taxes on LLC income that has already been redistributed as wages or other forms of investment return.
In other words, the LLC itself isn't required to pay any taxes; instead, all of its profits "pass-through" to the LLC's owners, who then report them on their personal tax forms.
According to the Tax Foundation, this structure benefits over 90% of LLCs, allowing them to avoid corporate taxation and reduce overall tax liability.
By default, the Internal Revenue Service (IRS) treats every LLC as a disregarded entity for tax purposes. This implies that the LLC does not pay taxes and has no legal existence apart from its owners.
"Pass-through taxation implies that an LLC doesn't submit a corporate income tax return to the IRS. Instead, after covering expenses and debts, any remaining revenue is taxed directly to the LLC owners or members."
- Delina Yasmeh, J.D./Tax LL.M, Distinguished Expert in Mergers & Acquisitions
The Benefits of Pass-through Taxation
Drawing from our experience running several LLCs, the main tax benefits of pass-through taxation include:
LLC Tax Status
A pass-through entity, like an LLC, offers flexibility as owners can choose their taxation method while maintaining flow-through benefits.
For single-member LLCs, the owner reports business income on their personal tax return, and the LLC doesn't file separately.
Multi-member LLCs can opt for partnership, corporate, or S corporation taxation, with the partnership being the default option.
LLC members can choose corporate taxation by filing Form 8832 with the IRS, but the election should be made when the LLC is formed; otherwise, the default is partnership taxation for multi-member LLCs [1]. According to the IRS, nearly 10% of multi-member LLCs elect corporate taxation within their first year of operation to leverage tax planning benefits.
From my experience managing partnership taxation, each member reports their share of income on personal returns, and the LLC doesn't file separately.
Corporate taxation for an LLC resembles regular corporations; the LLC files its own tax return and pays corporate income taxes.
S corporation taxation is similar to partnerships, passing income to owners, and doesn't incur corporate-level taxes.
In contrast, C corporations pay corporate taxes and file separate returns, but they can benefit from certain advantages like double taxation of dividends.
Other Types of LLC Taxes
Business owners who choose to set up an LLC for their business face many federal, state, and even local taxes.
The most common types of federal tax entities that apply to LLCs include:
- The federal income taxes
- Employment taxes (including Social Security and Medicare)
- Federal excise tax on certain items such as alcohol or cigarettes
- Federal income tax for self-employed individuals (the "self-employment tax")
- Franchise tax in some states
Some states also impose a personal income tax on LLC owners, and in some cases, the local municipality may assess a business privilege or occupancy tax.
We recommend researching the specific taxes that will apply to your LLC before forming it.
Related Articles:
- LLC Tax Rate Guide
- When Are Taxes Due for an LLC
- How Much Should I Set Aside for Small Business Taxes
- Limitations on Deductibility of LLC Member’s Share of Losses
Potential Drawbacks to LLC Pass-Through Taxation?
The potential limitations of LLC pass-through taxation include:
- LLC members must pay self-employment taxes on their profits, increasing their tax burden compared to corporate employees.
- Some states impose additional taxes on LLCs, which can reduce the benefits of pass-through taxation.
- LLCs may struggle to attract investors due to the complexity of pass-through taxation and a preference for corporate structures.
FAQs
Who Qualifies for the 20% Pass-Through Deduction?
Qualified Business Income (QBI) is the key to taking advantage of the 20% pass-through deduction, as stipulated by the Tax Cuts and Jobs Act.
QBI is defined as income from pass-through entities, including sole proprietorships, partnerships, S corporations, and LLCs taxed as partnerships.
Does S Corp Have Pass-Through Taxation?
No. Other than the tax on certain capital gains and passive income, an S corporation is not subject to federal income tax.
It is treated similarly to a partnership in that corporate taxes and shareholder taxes are "passed through" and reported on the personal tax returns of each owner.
What Is the Federal Income Tax Rate for an LLC?
The federal corporate income tax is a flat rate of 21% and doesn't directly apply to LLCs. However, this federal corporate tax does affect the profits that flow through an LLC in its pass-through taxation structure because these profits are taxed at individual rates.
References:
- https://www.irs.gov/forms-pubs/about-form-8832