When people are starting a business, it’s likely that they’ll consider the tax benefits of different company structures. In some cases, founders may create a limited liability company (LLC) specifically for its tax benefits.
Here, we’ll delve into the tax benefits of LLCs for business owners, as well as other pros and cons.
What Is an LLC?
An LLC is a type of business structure available in the United States. A kind of hybrid, it combines some characteristics of corporations with others from a partnership or sole proprietorship.
According to the IRS, LLC owners are called “members.” Depending on the state in which you set up the LLC, members may be individual people, other LLCs, or corporations. There is no maximum number of members that a company can have, and most states allow LLCs with just one member. Check your state for specifics.
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Tax Benefits of Forming an LLC
As mentioned above, company founders may choose an LLC structure especially for its tax benefits. Here, we go into detail about what those benefits are.
Limited Liability
An LLC, as its full name implies, provides limited liability to its members. This means that, if the company fails, the owners’ and investors’ private assets are not at risk and can’t be seized to repay company debts.
Flexible Membership
As noted previously, an LLC can have one member or many, and those members can be individuals or companies. This business structure gives owners significant freedom when starting their company.
Management Structure Options
LLCs can be managed by a member (owner) or by a hired manager. A member-managed LLC may be chosen if the company has limited resources or few members. An owner may select a member with management experience to oversee the business, or they may want all members to actively participate in the company’s operations.
A hired manager is someone who is not a member but has the appropriate experience and skill sets to run the LLC. An accountant or financial advisor can go into detail about the tax benefits of member-manager vs. hired manager approaches. (Here’s what to know if you’re filing taxes for the first time.)
Pass-Through Taxation
LLC member-owners have some control over how their business will be taxed. If there is only one member, it will automatically be treated like a sole proprietorship, and if there is more than one, like a partnership. In those cases, business income will pass through the business to the member-owners, and they’ll only get taxed once. Members will report income and losses on their personal tax returns, while the LLC itself is not taxed. (Learn how business income differs from other types of income.)
Because income and losses are reported as part of members’ personal financial pictures at tax time, taxes will be owed at each member’s personal tax rate.
Alternatively, the LLC owners may decide to be taxed as a corporation. If they choose an S-Corp structure, pass-through taxation still applies.
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Heightened Credibility
When someone opens an LLC, it shows that they’ve gone beyond just hanging a shingle. Instead, they went through the decision making and paper filing processes involved in setting up the LLC.
Limited Compliance Requirements
According to the U.S. Small Business Association (SBA), another form of business structure — the corporation — has the strictest requirements. In contrast, LLCs have some but fewer.
In general, an LLC should maintain a current operating agreement, hold annual meetings, ensure that they have appropriate shares recorded for each member, and keep records if membership interests transfer. (Find out if you can use a personal checking account for your business.)
Disadvantages of Creating an LLC
So far, the LLC sounds like the ideal low-maintenance company structure. However, there are several caveats to be aware of.
Cost
Forming an LLC can cost a few hundred dollars, which may be more than what a small business wants to spend. The company will also need to file annual reports along with annual fees and taxes. These taxes and fees may cost a miniscule amount or several hundred dollars annually.
No Stock Ownership
When a corporation wants to raise funds, they sometimes issue shares of stock. An LLC cannot issue stock.
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Transferable Ownership
Some states may require that an LLC be dissolved if there is a change in ownership. If the people starting the business expect to take in outside investors over the years, a corporation might be a better choice.
How to Form an LLC
Once you’ve decided to start an LLC, you’ll want to choose and reserve a company name that doesn’t conflict with currently existing ones. Typically, an LLC must have what’s called a registered agent: someone who will handle official documents for the company.
Then, you’ll need to document the nuts and bolts of the operating agreement that describes the structure of the company. This can include who owns what portion of the company and who gets to vote on which issues. You’ll detail how profits and losses will be addressed, how the company will be managed, when meetings will be held, and how to handle the business if a member leaves the company or dies. This document should also describe what should happen if the company goes out of business.
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How LLCs Are Different From Other Business Entities
An LLC is formed to be a legal entity that’s separate from its owners and is responsible for its business debts. Here’s how an LLC differs from other company structures.
LLC vs Sole Proprietorship
Profits in an LLC are only taxed once because of the pass-through taxation structure. This is reported on and addressed through owners’ personal tax returns by filing a Form 1040, Schedule C, listing profits or losses. As an LLC owner, you may be taxed as a sole proprietor, a partnership, or a corporation.
A sole proprietorship is owned by one person and is the simplest structure available. A sole proprietorship also involves pass-through taxation with the business owner paying taxes on the business’s profit. There isn’t as much flexibility in filing as a sole proprietor as there is with an LLC.
LLC vs S-Corp
An LLC is a business structure. An S-corp, meanwhile, is a tax classification. Many businesses decide to have their LLC taxed as an S-corp. The nuances can be complicated, so it makes sense to consult your personal accountant or other professional before making this decision.
LLC for Rental Property
If you create an LLC to buy rental homes, you’ll have the benefits of no personal liability and pass-through taxation. There can be a flexible ownership structure, personal anonymity, and fairly simple reporting.
However, it may be harder to finance rental property as an LLC. There can also be significant fees to get the LLC up and running. LLCs for rentals can be more complex at tax time, and property transfers can also be more complicated.
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How to Choose the Right Business Type
Consider how simple or complex your proposed business will become. Do you plan to basically run the business yourself, or will it ideally turn into something bigger? What kind of legal protections will you need based on your business plans?
Entrepreneurs should also weigh the tax benefits of LLCs and sole proprietorships. The two structures, along with partnerships and S-corps, feature pass-through benefits, meaning that profits are taxed only when they’re paid to the company owner(s). A C-corp, meanwhile, is taxed as a company as well as when shareholder payouts are made.
Consult your accountant or financial advisor for specifics on your situation.
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The Takeaway
Limited liability companies (LLCs) come with plenty of advantages and a few disadvantages. As its name implies, the owners’ and investors’ private assets are not at risk if the company should struggle financially. Owners of the LLC are referred to as members. Membership may range from one individual to multiple individuals to other companies.
A major benefit is pass-through taxation, where income passes through the company to its members, who report it on their personal taxes. One disadvantage of LLCs for very small businesses is the startup cost and annual fees, which can run to several hundred dollars a year. Consult a professional to find out whether an LLC is the right fit for your business plan.
No matter what business structure you choose, it’s important to keep track of your finances. SoFi’s spending app provides you with an easy to use online budget planner so you can stay on top of your finances.
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FAQ
What are the tax benefits of having an LLC?
With an LLC, you’ll have flexibility in deciding the structure under which your company will be taxed. There are more tax benefits of an LLC, including pass-through taxation, which means you’ll only get taxed once at your individual tax rate.
What are the benefits of a limited liability company?
They can include limited liability, meaning that owners aren’t personally responsible for company debts; flexible structures; pass-through taxation; more credibility; and fewer compliance requirements compared to a corporation.
What is the best tax option for an LLC?
Each situation is unique, so consult your accountant or financial advisor for specifics.
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This article is not intended to be legal advice. Please consult an attorney for advice.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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