When deciding on a business structure, one of your primary concerns should be taxes. If you are considering a limited liability company (LLC), keep in mind that the Internal Revenue Service(IRS) doesn't have a special tax classification for LLCs. This gives you the freedom to choose how your LLC will be taxed.
An LLC may be taxed in four primary ways:
- As a sole proprietorship
- As a partnership
- As a C corporation (C corp)
- As an S corporation (S corp)
If you own a single-member LLC, you may elect to be taxed as a sole proprietorship, partnership, or C corp. If your LLC has more than one owner, a sole proprietorship isn't an option, but the remaining three are.
Here are some factors to consider when deciding how you want your LLC to be taxed.
- Tax rates. To choose your LLC's tax status, you should consider whether your business would be better served by IRS treatment as a "disregarded entity" or a corporation. A disregarded entity—meaning the LLC is disregarded as being separate from its owner—is treated the same as a sole proprietorship for tax purposes. In that case, your LLC's income is treated as personal income. This "pass-through taxation" simplifies your tax return. On the other hand, if you choose corporate status, your income is taxed at a lower corporate rate up to a certain amount as set by the IRS.
- Double taxation. Both the corporation and its shareholders pay tax on their income, leading to double taxation. A corporation also pays corporate taxes. An LLC can help you avoid double taxation unless you structure the entity as a corporation for tax purposes.
- Business expenses. LLC members may take tax deductions for legitimate business expenses, including the cost of forming the LLC, on their personal returns. Deductions, like profits, are divided among owners based on a percentage of ownership. Note that for certain employee benefits—such as medical, disability, and life insurance—a C corp may be a better choice, or else the benefits could become taxable to LLC members. Moreover, LLC owners may also be eligible for the Qualified Business Income deduction, which allows LLC owners to claim a 20% deduction from their business net income, above and beyond business-expense deductions.
- Capital expenditure deductions. LLCs may take capital expenditure deductions for purchases of goods or equipment that the business will use over a one-year period. The deduction is divided over the course of the year, according to IRS provisions.
Once making your decision on tax status, your next step is more paperwork. That is, if you want your LLC to be taxed as anything but a sole proprietorship, you must file Form 8832 to inform the IRS of your LLC's partnership or corporation status.
For most small business owners, structuring a business as an LLC offers the most versatility in determining how the business is taxed, while also offering the limited liability of a corporation but with less formality. Because every LLC is unique, you may wish to obtain solid legal advice before moving forward on tax status selection.