Everyone seems to want to start an LLC but what makes Limited Liability Companies (LLCs) so special? Let’s break it down so you can understand the importance of LLCs.
What’s special about LLCs?
LLC owners are called members. Single-member LLCs have one owner. Multi-member LLCs have two or more members and by default are a partnership.
LLCs have both legal and income tax advantages.
I’m not a lawyer but, in general, if you create an LLC it can help offer legal protection for your personal assets. As long as you keep the business separate from personal, this protection is similar to a corporation. This means no commingling of money, assets, etc.
Let me repeat. You MUST keep your business 100% separate from personal. This means a separate bank account, credit card, etc. ALL income and expenses must come out of the business account. The minute you commingle the protection the LLC offers can be broken.
Single-member LLCs Tax Basics
Contrary to popular belief, the LLC itself offers no tax benefit.
I hear it all the time. I want to form an LLC to help me save on taxes. By default, it doesn’t help.
By default, a single-member LLC is a sole proprietor for tax purposes. You simply report all income and expenses on a Schedule C as part of your Form 1040.
If you have an LLC rental, then the rental activity gets reported on a Schedule E of your Form 1040.
You’ll also need to create a Schedule SE to report your self-employment taxes. If you’re using software, this should be automatic if you have net self-employment income.
Multi-member LLCs Tax Basics
By default, multi-member LLCs are treated as partnerships for income tax purposes. This means the LLC must file a partnership tax return or Form 1065. Form 1065 produces a K-1 for each member to use on their personal income tax return. This reports the member’s share of profits and losses.
The LLC itself does not pay federal income tax. This is called pass-through income because the income and expenses from the LLCs are passed through to the members who then take it into account on their own returns.
Advantages of pass-through taxation
You can deduct losses from LLCs passed through to you on a personal return or Form 1040. These are subject to the following federal income tax limitations:
- passive loss rules
- at-risk rules
- excess business loss disallowance rule
- membership basis limitation rules
For tax years 2018 to 2025, the Tax Cuts and Jobs Act allows for the qualified business income (QBI) deduction. The deduction can be up to 20 percent of QBI passed through to you via an LLC. If you’re higher income, there are limitations. The QBI deduction is set to expire at the end of 2025 unless it gets extended.
For the purpose of determining losses you can deduct, you can receive additional tax basis from your LLC or LLC liabilities. This is a pretty nice tax advantage that allows you to deduct pass-through LLC losses in excess of your investment in the LLC. As usual, this is subject to limitations.
The other advantage is being able to make tax-free transfers of assets (including cash) between the members and the LLC. This is an advantage over operating an S or C Corporation where the transfer of cash is taxable.
Disadvantage of pass-through taxation
Members of LLCs in partnerships owe self-employment taxes. This is your Social Security and Medicare tax of 15.3%. In contrast, if you operate as an S or C Corp, Social Security, and Medicare are only paid on wages or salary to you and the other owners. If you’re high income, this is an important factor in favor of operating as an S Corp.
Electing S Corp Treatment for Tax Purposes
There is an option to treat LLCs as a corporation for federal income tax purposes. This is what we call a tax election. You can make the S Corp election using Form 2553.
Please note, an S Corp is only advantageous if the business is earning a higher income (approximately $75,000 or more of NET profit). The income can vary where you’ll see tax savings but this is a good starting point. Make sure you plan to see this revenue each year. I call this proven revenue. The business should be growing or keeping steady at that higher income. Otherwise, you don’t see tax savings but you will see extra hassles and costs to maintain the S Corp.
Don’t make this election lightly. It does come with extra responsibilities and is NOT the right fit for everyone. There is a separate tax return to prepare (Form 1120S), payroll to run, basis to track, and more. Bookkeeping itself also gets a little more complicated.
Do your homework before making this election so you don’t run into trouble with the IRS.
Don’t Forget about States
Everything shared so far is for federal income tax purposes. Don’t overlook your state rules and regulations. Not every state is the same. Make sure to understand all the state legal and tax consequences when deciding to operate LLCs.
This is particularly true for professional practices where you may be prohibited from operating as an LLC. It’s important to do your homework here.
LLCs offer no specific tax savings alone.
Single-member LLCs are sole proprietorships reported on a Schedule C.
Multi-member LLCs are by default partnerships and file a separate tax return, Form 1065.
S Corp is a TAX election that is favorable for some but not all taxpayers.
Don’t neglect to understand your state’s rules and regulations.