Limited Liability Company Tax Advantages

By Lisa Magloff

Limited Liability Companies (LLCs) are an increasingly popular business structure. One reason for this is the flexibility that they allow in terms of taxation. This flexibility allows the LLC to choose whether to be taxed as a sole proprietorship (if there is only one owner, called a "member" in an LLC), a corporation or a partnership. Members of an LLC may also be allowed to list the profits and losses on their personal income tax returns, avoiding double taxation.

Pass-Through Taxation

One major advantage of an LLC is that all of the profits, losses and deductions of the business can be reported on the members' personal income tax returns. This is called “pass through” taxation, because all of the profits and losses pass through the business and go directly to the members. This allows members to pay tax at their individual tax rate, thus avoiding double taxation, where the business pays a corporate tax and the members also pay tax on their income from the business.

Flexible Tax Structure

LLCs are normally treated by default as a pass-through entity. If there is only one member, the owner reports the LLC's income on her own tax return on Schedule C. For LLCs with multiple members, the LLC is treated by default as a partnership and members' income from the LLC is then treated as earned income and is subject to Social Security and Medicare contributions. However, an LLC may also elect to be treated as either an S or C corporation. If it is taxed as an S corporation, all income will be taxed as passive income and will not be subject to Social Security and Medicare contribution. If the LLC is taxed as a C corporation, its income is taxed at the corporation tax rates, and members also pay taxes on any income they take from the business.

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Members' Compensation

An LLC allows flexibility in payment to members, which can have tax advantages. In an LLC, members may be compensated using either a guaranteed payment scheme or distribution of profit. Guaranteed payments are regular payments for services to the business, or for use of capital. Guaranteed payments are treated as a business expense and are deductible from the net profit of the LLC. The member receiving the guaranteed payment does not pay FICA tax withholding, but does pay self-employment taxes. Distributions are shares of the business's earnings, paid to all members. Distributions may be treated for tax purposes as return of capital, and so may not be subject to additional tax. However, if the distributions are regular, they may be treated as guaranteed payments, and subject to self-employment taxes.

State Tax Advantages

In most states, LLCs are taxed in the same way as the Internal Revenue Service (IRS) determines federal income tax. The LLC does not itself pay a tax, and the members report their profits and losses on their state personal income tax returns. However, some states do charge the LLC an income-based tax. For example, California charges LLCs a tax on income over $250,000 a year. Some states also charge a yearly fee to LLCs.

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Advantages & Disadvantages of a Single-Member LLC

References

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