Many entrepreneurs decide to form an LLC in order to protect their personal assets from seizure by a bank or lender, but there are several tax advantages that incentivize LLC formation as well.
One advantage to forming an LLC is that you can avoid “double taxation.” An LLC does not get taxed directly. Rather the business owner claims the profits on their personal income tax forms, benefiting from what’s known as “pass-through taxation.”
LLC types that can affect how your business is taxed as an entity:
Single-member LLC as a disregarded entity: The business owner pays taxes on the profit as personal income in addition to self-employment tax. There is no need for the LLC itself to file for any taxes.
Example: Michael’s business earns $70,000 net profit at the end of the year. He pays taxes on the $70,000 at his individual tax rate in addition to a self-employment tax, which is 15.3% on the first $113,700 in 2013.
Multi-member LLC as a partnership: The business reports income on a separate 1065 partnership tax return. Then, each business owner pays self-employment taxes on their separate portion of profits.
Example: Tim and Murphy’s business earns $80,000 net profit at the end of the year. Each owner pays taxes on $40,000 at their individual tax rate in addition to a self-employment tax, which is 15.3% on the first $113,700 in 2013.
LLC as a C Corporation: The LLC can elect to file a corporate tax return, and thus the owners do not pay the self-employment taxes. However, the owners are taxed on any dividends distributed to them out of the profits. The business also owes payroll taxes for wages paid to LLC members.
Example: Chad’s business earns $120,000 in profit at the end of the year. The business pays $46,800 in tax according to the 39% rate in 2013 and Chad is taxed at 15% assuming he receives the remaining profit as a qualified dividend.
LLC as an S Corporation: LLC owners are taxed on their respective share of the company’s profits but avoid the self-employment tax. The LLC also pays payroll taxes for income earned by all employees.
Example: Mark and Tom’s business earns $200,000 in profit. Instead of paying tax on the profit as a business, each owner reports their share of the profit (after payroll taxes) on their individual income tax return.
Deciding which type of LLC to form can be a tricky decision and will depend on a number of factors that apply to your particular situation. Pay particular attention to the number of owners, the number of employees, and the expected profit for your company. The size of the business will typically be the deciding factor in your decision.