Tax Benefits Of Setting Up An LLC
04 November 2023
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A limited liability company (LLC) is an extremely popular format for business entities. A significant reason for the popularity of the LLC structure is that an LLC protects its owners’ assets. The owners of an LLC are called “members.” They are not held responsible for the debts and liabilities of an LLC. The liability of LLC members is limited to the risk of losing any investment made in the LLC, and that is all.
Examples Of The Liability Limitation Of An LLC
Example 1: Suppose you invest $100,000 in the startup of a new LLC. The LLC uses this money to buy a franchise. The LLC sets up an unsecured business credit line of $25,000, which does not require a personal guarantee from the LLC owners. The franchise opens but fails to operate well enough to make a profit.
After a year, the money runs out, and the company faces bankruptcy. As the owner, you lost the $100,000 you invested at the beginning, but you are not responsible for the $25,000 credit line that is unsecured and does not have your guarantee.
Example 2: Suppose you are a commercial real estate developer and own many properties. Having a separate LLC to hold the ownership of each property manages the risk of a lawsuit claim on one property harming the others. Such a lawsuit cannot impact the other properties owned by a different LLC.
Another significant reason for the popularity of the LLC structure is that an LLC offers many tax advantages.
Tax Advantages Of An LLC
The tax considerations of an LLC include deciding about pass-through taxation and optimal tax classification, understanding business income and deductions, reducing self-employment tax, and the Tax Cuts and Jobs Act (TCJA) Section 199A deduction.
Many who are starting a business benefit from using an LLC. An LLC is unique because the owners decide how the Internal Revenue Service (IRS) treats the company for federal taxation purposes.
Pass-Through Taxation
An LLC is, by default, a non-taxable entity for federal taxes in the eyes of the IRS. Unless the LLC owners choose otherwise, the LLC does not pay any federal income tax. Instead, any profits and losses that are distributed or allocated from the LLC to its owners are accounted for as the personal income/loss of the tax Benefits of Setting Up an LLCe owner.
The owners pay any federal income taxes due on the distributions they receive from the LLC, according to their tax brackets.
Avoid The Double Taxation Of A C-Corporation
An LLC structure avoids the double-taxation problem of a C-corporation. A C-corporation must pay income taxes on profits. The owners must report, as income, any payments to the owners from the corporation. This results in taxing the same profits twice. Moreover, the losses of the corporation do not pass through to the owners for a tax deduction.
Tax Classification For The LLC
The members of the LLC have the option to use the default format of an LLC. This means that the LLC is taxed as a sole proprietorship for a single-member LLC, and an LLC with more than one member is taxed as a partnership. The 1020 tax return uses a Schedule C for single-member LLCs, or you use a 1065 Partnership Return for LLCs with more than one member.
Choosing A Tax Classification For The LLC
The members of an LLC can change the tax classification after the LLC formation by completing and filing an IRS Form 8832 — Entity Classification Election. If this election is made, the members can choose to have the LLC taxed as a C-Corporation (bringing back the double-taxation problem) or an S-Corporation. The IRS treats an S-Corporation as a partnership. An S-Corporation avoids the double-taxation problem and is a pass-through entity.
Why would you want to change the taxation to a C-Corporation?
A common reason for this option is that a corporation can deduct health care expenses and other benefits, whereas the pass-through LLC and its members do not have this ability.
Why would you want to change the taxation to an S-Corporation?
An S-Corporation saves on Social Security and Medicare taxes since members and managers are employees. The members and managers also avoid paying the self-employment tax that is required for the self-employed.
Sometimes, the calculation of taxes is less when you choose the pass-through LLC defaults. Depending on income and deductions, choosing a C-Corporation or S-Corporation with the IRS for federal tax purposes may produce a lower or higher tax liability. Consult with a tax expert to get a recommendation for your circumstances.
Income Distributions And Loss Allocations
An LLC can make income distributions and loss allocations based on the terms of the LLC’s operating agreement. There is no requirement that income distributions and loss allocations be made according to a member’s ownership percentage.
If an LLC has a net loss in a particular year, the members may use these losses to offset other income on their tax returns. This loss may help reduce their overall taxable income from all sources and might result in reduced overall tax liability.
Examples Of Income Distributions And Loss Allocations
Suppose the members of an LLC are family members and have different tax rates. Income distributions and loss allocations can be organized under the LLC’s operating agreement to minimize the tax burden of the entire family, giving more income to those members in a lower tax bracket and allocating a greater portion of the losses to those members with higher income and tax brackets. These calculations are complex, so use a tax professional for advice about your circumstances.
Business Expense Deductions
For pass-through forms of an LLC, the deductions are taken from personal income and may be fewer than are allowed as business deductions for an LLC that asks the IRS to treat it as a corporation.
The corporation type for an LLC can take advantage of many business deductions for rent, salaries, health insurance, other employee benefits, equipment, marketing, legal, continuing education, training, and more. Maximizing legitimate deductions helps lower tax liability. Capital equipment can create a deduction for the purchase expense or depreciation over time.
Retirement Plans
An LLC can offer retirement plans for its members and its employees. Popular retirement plans are IRAs (of various types) and 401(k) plans. Standard IRAs allow tax-deductible contributions. Roth IRAS allows tax-free growth of portfolio value. These strategies help reduce the taxable income for LLC members and the company.
Self-Employment Tax
Self-employment tax may be reduced, depending on how the members of an LLC choose an IRS tax classification. For a default LLC tax classification, which the IRS recognizes as a sole proprietorship (for single-member LLC) or a partnership (for an LLC with more than one member), all earnings are subject to self-employment tax.
However, for an LLC that requests the IRS to treat it as a corporation, the LLC can employ members and pay them a reasonable salary and benefits. These salaries are subject to payroll and income taxes, avoiding the self-employment tax. Additional money can be given to the members as distributions that are not subject to payroll taxes.
Tax Credits And Incentives
Tax credits and incentives may be useful for LLCs and their members. The Tax Cuts and Jobs Act (TCJA) Section 199A deduction is a pass-through deduction. The TCJA became law in 2017. It allows a Qualified Business Income (QBI) deduction, which LLC members, sole proprietorships, partnerships, and S-Corporations can use. With this deduction, LLC members can claim a tax deduction of up to 20% of their qualified business income before calculating their federal tax liability.
Key Takeaways
An LLC is a popular form for a company because it protects its members from liability. Additionally, there are many tax advantages of having an LLC and strategic ways to use the options to reduce taxes.
Disclaimer: This information is current as of the date of publication, yet it is subject to change. It is important to consult with a tax professional for a review of your circumstances and the pertinent tax laws in your jurisdiction.
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