While you may have started running your business as a sole proprietorship, it’s worth exploring options for a new business structure once your business starts to grow.
Choosing the right business structure is often a question of size, scale, finances, and tax advantages. Many small businesses start as sole proprietorships and develop into LLCs or corporations. While both have benefits, forming a limited liability company, or LLC, is most like a sole proprietorship, and many business owners enjoy the specific tax benefits offered by an LLC.
What is an LLC?
A limited liability company, or LLC, is formed at the state level. You file articles of organization or a certificate of formation and create an official company for your business. This is like—but not the same as—a corporation.
LLCs offer the protection of corporations by offering owners limited liability for legal purposes. It creates a legal separation and keeps your personal assets safe from any business liabilities or debts.
Despite this, LLCs don’t have to pay taxes as a corporation, because the Internal Revenue Service considers LLCs on par with partnerships and sole proprietorships. However, you still have the flexibility to file your taxes as a corporation if you so choose.
How does an LLC pay income taxes?
Like a partnership or sole proprietorship, single-member LLCs and multi-member LLCs both avoid double taxation. Double taxation happens in corporations when a company’s profits are taxed twice: once when the business’s income taxes are filed and then again as owners file their own income taxes with the IRS.
An LLC’s profits or losses flow through to owners, who are then taxed at a personal level in a process known as pass-through taxation. As a result, LLCs do not pay taxes separately on income. Instead, for income tax purposes, an LLC’s income is only taxed once on a personal tax return.
The rules of LLCs vary by state, but in most states, there is no limit to how many individuals can be part of an LLC. A single-member LLC can be formed by the sole proprietor looking for a level of legal protection and some tax advantages, or a multi-member LLC can be formed by potentially thousands of individuals with common business practice. With this flexibility comes a variety of tax classifications by the IRS for federal income taxes.
Single-member LLCs can file taxes as a sole proprietor using IRS Form 1040 after preparing a profit-or-loss report on IRS Schedule C.
A multi-member LLC usually files as a partnership by preparing a Schedule K-1 for each of its members following the instructions on the informational IRS Form 1065. Shareholders in an LLC report usually their profit or loss using Schedule E, if the LLC has completed an S-Corp election.
Working with a tax advisor can help business owners find the optimum way to file taxes that reduces their tax burden. You can also read more about filing taxes as an LLC to understand the implications and process.
Learn more about the differences, including paying taxes, between sole proprietorships and LLCs.
Tax advantages of an LLC
LLC tax benefits are multi-faceted, so we’ll walk through them below.
LLCs avoid double taxation while enjoying personal liability protection
Unlike a corporation that pays taxes twice on the same profit, first as business income and then again as owner income, LLC shareholders are only taxed once on profits in their personal income.
LLC allows a small business owner tax deduction
The Qualified Business Income Deduction (QBI) is available only to small business owners, which includes LLC owners, but not corporations. The QBI deduction allows LLC owners an extra deduction in addition to deductions for normal business expenses on income tax returns. We’ll explore the QBI deduction in more detail below.
Tax disadvantages of an LLC
Of course, there are a few potential tax disadvantages of forming an LLC.
Self-employment taxes are required
The self-employment tax includes Social Security and Medicare payments, and LLC owners must pay these taxes in full on their personal taxes, although they get a deduction for one-half of this self-employment tax paid. Corporation owners who are employees, on the other hand, pay only half of these taxes as individuals, since the corporation pays the other half.
All profits are taxed regardless of income
In a corporation, individuals don’t pay taxes on income until it’s distributed. Most corporate income is distributed as dividends. LLC members, however, pay taxes on their portion of the profits, even if the profits haven’t been distributed yet. That means that there is a possibility of paying income taxes on money that hasn’t made it to you yet.
Common tax deductions for LLCs
All business types have tax deductions. Here are some common tax deductions your LLC might benefit from.
Qualified Business Income deduction (QBI)
LLCs are eligible for the Qualified Business Income deduction, or QBI. This deduction was established in 2017 to help reduce the tax rate or obligation for small business owners. With the QBI deduction, up to 20% of the business income can be claimed as a deduction. It is set to sunset, or not be available, in 2025.
Both C corporations and taxable LLCs may deduct health insurance premiums for the employed owner and family.
Taxable LLCs (as well as C corporations) may deduct the premium for disability insurance for business employees, including the owner.
Office supplies and connectivity
The vast majority of companies require both phone and internet services. Both of these are included as qualified deductions for small businesses like LLCs. Other office supplies, including necessary technology and furniture, can be deducted as well.
For 2022 forward, corporations, at the entity level, can make charitable donations of up to 10% of the company’s taxable income (up to 25% for 2021). LLC owners can make personal charitable contributions to public charities of up to 60% of gross income (contribution base = AGI - charitable deduction - NOL carrybacks) if the donation is in cash. If a combination of the donation is of ordinary income property and cash, the limit is 50%.
LLC owners can use the home office deduction to write-off expenses for a home office that is used routinely and exclusively for business administration and management. This includes deductions for maintenance and utilities for the space. Learn more about using the home office tax deduction.
Business vehicle and mileage
The IRS allows LLC owners and employees reimbursement for mileage and vehicle use during business operations, but there are limitations to this exemption. The vehicle must be owned by the individual and used exclusively for business use or leased for partial use.
How Bench can help
Regardless of your business structure, Bench can help. We help you manage your monthly bookkeeping so that you’re ready for tax filing quarterly and at year-end. If you’d like, we can even help you file taxes as well.
When our team handles the numbers, you can focus on running your business—not the paperwork. You’ll have the confidence of knowing you’re compliant with the IRS, your numbers are correct, and your financial house is in order. Learn more.
Is an LLC right for your business?
Every business is unique, and so is every business owner’s tax situation. Forming an LLC may be a great tax choice for your business, but only an analysis of your current legal position can tell. To make the best choice for you and your money, discuss the specifics of your small business with your legal advisors.