What Are the Tax Benefits of Forming an LLC?

Starting your business is no easy task. Aside from raising capital and figuring out operations, you’ll also need to deal with government requirements and taxes. The latter is likely to take a huge chunk of your time, depending on which business entity you decide to go with — and it’s important to choose right. As we outlined in ‘5 Tax Issues for Startups to Pay Attention To‘, the formation of the startup and its full structure should be determined by the business owner from the start.

While you have options such as sole proprietorship, partnership, corporations, and S corporations, structuring your business as a limited liability company (LLC) may offer you the best, and most versatile, tax options. Not to mention, forming an LLC is a short process that requires less paperwork and costs. ZenBusiness documents how it can be done in just five easy steps, from naming your LLC and choosing a registered agent to applying for an Employee Identification Number and reviewing tax requirements. While this varies by state, the general concept remains constant.

However, the true advantage of this title comes in the form of tax benefits.
The Main Tax Benefit of Forming an LLC
LLCs grant business owners, who are also called ‘members’, significantly greater federal income tax flexibility compared to other business entities, as it lets a business owner decide how they will be taxed. They can be taxed as a sole proprietor, a partnership, an S corporation or a C corporation. This choice can be made by filing IRS Form 8832.

How does this work? The key concept associated with LLC taxes is the ‘pass-through taxation’, which The Balance describes as the way an LLC’s earnings can be passed straight through to business owners before paying corporate federal income taxes. This is similar to a sole proprietorship or partnership, as they are also pass-through entities. Because of this, LLCs, sole proprietorship, and partnerships need not pay federal income taxes themselves. Instead, income gets passed through to the business owner, who pays taxes given their individual income tax rates.

On the other hand, this is different compared to C corporations, as they experience double taxation. Not only does the business itself have to pay taxes based on gross profit, but any distributions made to the owners also gets taxed as individual income. Overall, avoiding double taxation as an LLC is one of the main benefits, as it helps save significant money in the long run.

Additional Benefits of Forming an LLC

As profits and losses get passed on to an LLC member’s personal tax return, business owners get to deduct some of the business losses that occur during the tax year. While this has a limit and may not cover the whole loss given that LLCs offer limited liability to the owner, this can still be a financial lifesaver during catastrophic losses.

Additionally, LLCs allow members to lease personal assets to the business. For instance, if you use your home office to run your LLC, your LLC could lease the space from you (even though you’re an owner). This lets you create a business expense that your LLC can write off. Keep in mind, however, that these expenses must be legitimate business expenses and having a formal lease agreement in place is needed.

Tax Limits of an LLC

Of course, LLCs still have to pay some form of tax — how much just depends on how you set it up, as a C corporation set up is significantly different compared to a sole proprietorship. If following the latter, however, business owners may have to file for quarterly tax payments of your estimated federal income taxes, as income from an LLC that is taxed as a sole proprietorship won’t be subject to withholding tax.

There are also some limits to what expenses an LLC can deduct from tax. For instance, you might not be able to deduct benefits like health and life insurance, unlike C corporations. If you choose to offer these benefits as an LLC, you may have to pay taxes on them.

The Bottom Line

Overall, small business owners who choose LLC as their business structure can take advantage of the versatility in determining how their business gets taxed, while also offering the limited liability of a corporation with less formality. Given how an LLC can be set up at a lower cost and with less hassle compared to C corporations, an LLC may be one of the best options to consider.