A limited liability company (LLC) is a business entity designed to protect its owners from being held personally liable for business-related debts. Limited liability companies have gained popularity because they offer a lot of flexibility for their owners.
One of the benefits of running an LLC is that the income and losses from the business can "pass-through" to the individual owners.
This means that the LLC itself does not pay any federal taxes on its income. Instead, the business income and losses are passed through to the individual owners.
Pass-through Taxation Explained
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 across society either as wages or other forms of investment return.
In other words, LLCs that pay taxes at the individual level must report income and losses on their personal income tax returns and may be able to reduce their total tax burden through certain deductions.
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.
Pass-through entities are business organizations where business profits are taxed at the individual level. The tax levied on the business is not paid directly by it but indirectly through its owners when they file their personal income taxes.
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.
Instead, all profits or losses generated by an LLC "pass-through" to the company's individual members for inclusion on their personal income tax returns.
The Benefits of Pass-through Taxation
Owners of pass-through businesses can take advantage of special tax deductions or credits. For example, if you are self-employed and generate a net loss on your business income, the IRS may allow you to deduct some (or all) of that loss from your taxable income.
The main tax benefits of pass-through taxation include:
The ability to deduct your business losses from your income reduces the amount of tax you owe. Owners and shareholders can receive their share of LLC's profits as a return on investment (ROI) rather than dividends that are subject to double taxation.
The possibility for some or all of the business's net income to be paid out as compensation for services, which is subject only to payroll taxes (employed owners of pass-through companies may wish to compare this approach with receiving a salary).
The ability for an owner or shareholder of a pass-through business who has no employees and works full time at their own company to qualify for self-employment tax breaks.
The fact that pass-through businesses are not subject to corporate income tax. The corporate tax rate can be as high as 35%.
LLC Tax Status
A pass-through entity allows a lot of flexibility because LLC owners can choose how their business will be taxed and still retain the benefits of a flow-through entity.
LLCs that have only one owner/member are taxed as sole proprietorships. This implies that the LLC owner reports all business income and losses on their personal tax returns. The limited liability company does not file its own tax return.
There are two other types of taxation for LLCs with more than one member: partnership taxation or corporate taxation.
If a limited liability company has more than one owner (multi-member LLC), it can be taxed as a partnership, corporation, or S corporation. The default tax status for an LLC with multiple owners is a partnership.
However, the LLC members may choose to tax the company as a corporation by filing Form 8832 with the IRS.
The tax status of that particular business structure should be elected when the LLC is first formed. If it isn't, the IRS will default the company to partnership taxation (provided that it has two or more members).
Partnership taxation is where each member of the LLC reports their share of business income and losses on their individual tax return. The LLC does not file its own tax return.
Corporate taxes work the same way as regular corporations. The LLC files its own tax return and pays taxes on its income at the corporate rate.
S corporation taxation is very similar to partnership taxation, with a couple of crucial differences. First, S corps are pass-through entities like partnerships, meaning that business income and losses are passed through to the owners and then reported on their individual tax returns.
Because of this, S corporations do not pay federal taxes at the corporate level; they pass through all profits and losses to individuals and are responsible for taxation at the shareholder level.
On the other hand, C corporations have to pay federal taxes at the corporate level and must file their own tax return. However, a C corporation can receive certain benefits that partnerships cannot, such as double taxation of dividends (i.e., profits distributed to shareholders).
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. It's essential to research the specific taxes that will apply to your LLC before forming it.
If you're not sure which taxes apply to your LLC, consult with an accountant or a tax attorney. They can help you understand which taxes apply to your business based on the state in which it was formed and how filing as an LLC will affect any of these business taxes.
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.
Should an LLC Owner Take a Salary?
A business owner can't take a salary from the LLC. Instead, the LLC's profits and losses "pass-through" to the owner's personal tax return.
You can take a draw or distribution from a single-member LLC if you like. You may also receive money by drawing as long as your LLC is a partnership, even if it has multiple members.
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.
Is a Sole Proprietorship a Pass-Through Entity?
Yes, a sole proprietorship is a pass-through entity. It's the simplest form of business organization and has no distinction between owners and businesses, so it avoids double taxation at both levels.
A sole proprietor reports all profits or losses on his personal tax return as "business income."
Is a Single-Member LLC a Pass-Through Entity?
Yes, a single-member LLC is a pass-through entity. This means that the business's profits and losses of the LLC are "passed through" to its owner, who is responsible for paying taxes at a personal income tax rate.
Do LLC Members Pay Self-Employment Tax?
LLC owner is not required to pay Social Security and Medicare taxes on their own behalf because the LLCs are classified as pass-through entities. Instead, these expenses are referred to as "self-employment taxes" because business owners personally pay them to the Internal Revenue Service.
Are LLC Members Liable for Tax Debts?
No, members are free from the tax liability of the LLC. Because they do not have direct ownership of the company, they cannot be held personally responsible if something goes wrong.
Unless they pierce the corporate veil (annul the limited liability protection of the company), members are not liable for any debts or wrongdoings of the LLC.
The only time an individual member might be held liable is if they were to personally guarantee a debt of the LLC. In this case, they would be on the hook for repayment even if the LLC could not cover it.
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.
To reap the full benefits of pass-through taxation, LLC owners should take taxation seriously and choose what's best for their business needs with great care.
It can be difficult to predict how much LLC income will come in every year, so if you are not careful about your choice of entity type, then you could end up paying more taxes than necessary or vice versa.
As such, consulting a tax professional who specializes in this area is an essential step before moving forward with any decisions on which form to use.
Once they know all of the facts like projected revenue, anticipated deductions/losses, etc., they will be able to make recommendations based on the company's individual needs.