[2 Minute Read]
The biggest benefit of an LLC is that it solves double taxation for small to medium businesses. However, it also offers flexibility, you can nominate your LLC to be taxed differently to the default pass-through setup. This article will explore this topic in more detail.
LLC Overview
Your LLC, if you already have one, is a legal entity. With that being said, it’s not taxed like an entity. For that reason an LLC is the most common type of business in the USA.
Forming a business, in general, is a good way of protecting your assets through limited liability. It allows you to separate your personal assets and finances from those of your business.
Your LLC will have its own tax identification number (EIN), bank account, name, agent, and address. Although you’ll be the one calling the shots, you won’t be liable for the debts or lawsuits of your LLC. There might be exceptions to this if you, for example, irresponsibly manage your LLC’s finances and entangle them with your personal assets.
If you manage everything correctly, your LLC will be completely separated from your personal affairs and will work as a pass-through entity.
Pass-Through Entity
As a pass-through entity, your LLC literally passes it’s profits and losses onto you for tax purposes. So, the LLC in the end, doesn’t pay tax—you do.
This might seem odd at first, but it’s the perfect solution for most people.
If your LLC was not a pass-through entity, it would pay tax on all its profits. You would then use some portion of the profits for yourself (dividends and salary), and the other portion for keeping your business running.
The dividends that you’d pay yourself would be taxed again, at your personal tax level. So, in the end, the money would be taxed twice. Dividends are not seen as business expenses, so your business isn’t able to claim back on them. A salary would also be taxed, but it’s a business expense.
As you can see, having a pass-through tax entity is the better option as it allows you to just pay tax once for all the profits and distribute them as you want, without complications.
Single Member LLC
If you’re riding solo, so to speak, and are the only member of your LLC—all of the profits will be simply passed onto you and you’ll pay tax accordingly.
So, when doing the tax return, you’ll fill it out as if you were the LLC. Taking into account the expenses, liabilities, and profits.
If you’re a non-resident alien, you’re not going to be filing taxes in the U.S. (unless you have effectively connected income or other U.S. source income). Instead, you’ll file in your normal place of residence.
Multiple Member LLC
If your LLC has more than one member, you’ll divide the profits across all members and each one will pay tax on their share of the profits. So, you’ll be taxed like a partnership.
Usually, you’ll divide the profits equally, unless you have an agreement that states otherwise.
Remember, your operating agreement should set out the division of profits across the board of members. If your operating agreement isn’t up-to-date or doesn’t include this information, you can easily amend it.
Amending the operating agreement requires approval from all members. So, you propose the changes to the agreement, get approval from all members, then amend it.
Electing Corporation Tax Status
So, the LLC can be taxed like a sole proprietorship or a partnership. You can also elect your LLC to be taxed like a corporation.
Generally speaking, there are two corporation structures to choose from in the U.S.; a C-Corp and an S-Corp. We’ll briefly go over them so you understand how they differ.
C-Corporation
A C-Corporation is the standard type of corporation, and so it follows the traditional corporation tax route.
In the case of personal tax, the tax rates are usually adjusted for inflation. Whether the tax rates are fair or not, is a different story, but they are more flexible than the corporation tax rates.
A corporation is subject to a flat tax rate of 21%, this doesn’t change unless the congress passes a bill.
The profits of the corporation are paid to the owners as dividends and salaries. The owners then pay tax on this income.
If you want more information on the C-Corporation structure, head over to this article.
S-Corporation
An S-Corporation is a corporation structure that’s also a pass-through entity.
The S-Corp status is not available to all businesses, there are specific criteria a business has to fulfill to obtain this status.
There are also limitations on the ownership.
Since a S-Corp is also a pass-through entity, you wouldn’t normally elect your LLC to be taxed like an S-Corporation.
Why get taxed like a corporation?
You might be wondering who in their sane mind would want to go from a pass-through entity to a corporation.
If, for example, your personal tax is more than 21% because of how much your LLC is making, you might consider electing a corporation status.
As mentioned above, dividends are not seen as business expenses… Employee salaries and bonuses are. So, if you paid yourself a salary through your corporation, you might be able to minimize your tax.
Being an employee of your LLC means that you can provide yourself with employee benefits that can also be deducted as business expenses. Things like health and dental insurance, life insurance, company owned cars and equipment.
So, you basically get more control and room to play with how you receive money from your business and how it’s taxed.
Summary
To finalize, the LLC is a pass-through entity. This means that all it’s profits and losses are passed onto its members, and taxed only once at the personal level. This is a favourable tax structure because it avoids double taxation.
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