How are LLCs taxed? Tax advantages of an LLC and ways to reduce taxes
As a business structure, the primary purpose of an LLC is to protect the owners’ personal assets from debt collection and lawsuits targeting the LLC. However, LLCs also have certain tax advantages that make them popular, especially for small business owners.
Below is a guide to some of the most common questions current and potential business owners have about how LLCs are taxed and strategies LLCs can use to reduce their tax burden.
How are LLCs taxed?
LLCs are considered “pass-through entities,” meaning that the LLC itself does not pay federal income taxes on business income. Instead, the income “passes through” to the individual members of the LLC, who pay federal income tax earned from the LLC through their individual tax returns. This is how LLCs avoid double taxation (i.e. taxes at both the federal and individual levels), and this is the biggest difference between an LLC and a C Corporation (C corp).
Now, if the LLC has employees Moreover To its members or owners, an LLC must collect and pay payroll taxes, which include unemployment, Medicare, and Social Security taxes—also known as FICA (i.e., Federal Insurance Contributions Act) taxes, or the “self-employment” tax. Payroll taxes are paid according to a “pay-as-you-go” schedule established by the IRS and are typically paid via the Electronic Federal Tax Payment System, or EFTPS. Meanwhile, unemployment taxes are paid by the LLC, which must file Form 940 by January 31.street of the tax year; Payments are then made on the last day of each subsequent month during the quarter. To pay Social Security and Medicare taxes, an LLC files Form 941 on the last day of the month following each quarter, and taxes are generally paid on a monthly or biweekly basis.
How are LLC members taxed?
LLCs are taxed differently depending on the composition of their membership, single versus multiple members:
- If it is a single-member limited liability company: This individual will use Form 1040 to report income generated by the business and Schedule C to report expenses.
- If it is a multi-member LLC: An LLC files Form 1065, U.S. Return of Partnership Income, where the LLC reports business-related profits, losses, credits, and debits. The LLC then prepares Schedule K-1 documents for each member of the LLC. When filing their taxes, members use Schedule K-1 (Form 1065) to show their share of income, credits, and deductions received from the LLC. The percentage each LLC member receives is predetermined in the LLC operating agreement.
Do LLC members have to pay self-employment tax?
Yes. Members of an LLC are considered self-employed individuals, and FICA taxes (e.g., Social Security and Medicare) are not taken from their paychecks. Instead, self-employed people pay FICA taxes directly to the IRS — known as the self-employment tax.
In 2024, the self-employment tax is 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare. Technically, only the first $168,600 of earnings is subject to the Social Security portion, but individuals earning $200,000 or more pay an additional 0.9% Medicare tax — or, if they are filing jointly with a spouse, the minimum is $250,000.
To pay the self-employment tax, each LLC member calculates the self-employment tax themselves, using Schedule SE (Form 1040 or Form 1040-SR). There are ways to get around paying self-employment taxes, but they involve registering as an S corporation or C corporation and following certain rules that typically don’t apply to LLCs.
How can an LLC reduce its taxes?
There are a number of ways an LLC can reduce its tax burden, most of which are aimed at reducing the LLC owner’s taxable income. For example, business deductions may be claimed as capital expenditures that are subtracted from the LLC’s gross income. There are more complex ways to find tax savings, such as changing your company’s filing status, but they should only be pursued with the help of a qualified tax professional.
As an LLC, most business-related expenses are tax deductible. Therefore, in order to reduce a company’s total taxable income, it makes strategic sense to have as many business-related expenses as possible. These expenses can then be deducted from the LLC’s gross income, reducing the company’s overall tax burden. The IRS allows LLCs to deduct initial start-up costs—for example, marketing materials, travel, permits, legal fees, and research—and then allows a wide range of operational costs to be deducted, including:
- Computers, printers and other office supplies
- Telephone and internet
- Website development
- Graphic design (e.g. branding, logos, signage, business cards, etc.)
- Business/leisure meals
- Uncollected debts
- Medical/health care expenses
- Tools and technology
- Self-employment taxes
advice: Don’t just throw receipts in a shoebox and hope for the best. There’s an entire cottage industry dedicated to business expense tracking apps that can help business owners keep track of expenses. Most of them can organize expenses to make things easier when taxes are due, and some are already complete accounting software that LLC owners can use to manage their entire business.
Preparing retirement accounts
LLCs can set up their own retirement accounts and use them to either reduce or defer taxes. The most common vehicles for LLC retirement accounts are a SEP-IRA, Solo 401k, IRA (traditional or Roth), or Simple IRA. In each case, contributions are deductible because they are considered “compensation.” Each option has its pros and cons, but for tax purposes (in addition to saving for retirement), these accounts can help an LLC reduce its total taxable income, especially in years when the business is performing well and there is additional money available for investment.
Health insurance discount
One advantage of self-employment through an LLC is that health care premiums and other medical expenses (including vision and dental) are deductible. The only requirements are that the company must make a profit, and an LLC owner cannot qualify for a plan through his or her spouse’s employer.
advice: In addition to health insurance premiums, one often overlooked medical expense is mileage. Distance traveled to and from doctor appointments, to and from the hospital, and even to and from the pharmacy – all are tax deductible. If you decide to get a rideshare, that’s deductible as well. As well as the costs of glasses, hearing aids, medications, and any other unpaid medical expenses.
File as an S corporation
LLCs have the option of filing as an S corporation, the main benefit of which is to provide a mechanism to reduce self-employment taxes. Under the S Corp structure, the LLC owner can be considered an employee and receive a salary. Self-employment taxes must only be paid on salary (or salaries); The rest of the LLC/S profits can be distributed to members as dividends, which are not subject to self-employment tax. Under this arrangement, the company is still considered an LLC and is not subject to the administrative rules of an S corporation, but is treated by the IRS as an S corporation.
advice: It is possible for an LLC to file itself as a C corporation, so profits are taxed at the corporate income tax rate. However, this causes the risk of double taxation – that is, profits being taxed a second time on personal taxes. This strategy only makes sense under certain circumstances, and only an experienced tax attorney can determine whether it is a strategy worth considering.
Use the qualified business income (QBI) deduction.
The qualified business income (QBI) deduction, or Section 199A deduction, is another deduction available to qualified pass-through entities such as an LLC or S corporation. The QBI deduction is up to 20% depending on your total taxable income, and can be taken in addition to the standard and itemized deductions .
However, not every business can claim the QBI deduction. To be eligible, a company must be in a “specific trade or service business,” such as a lawyer, doctor, counselor, financial planner, or accountant. However, the list of possible professions also includes performers, athletes, farmers, and many other businesses that rely on the skill or reputation of one or more employees.
QBI is deducted from a company’s net earnings less capital gains/losses, dividends, or interest income. Starting in 2024, a solo filer earning less than $191,950 may be eligible for the full 20% deduction, while a solo filer earning $191,500 to $241,950 may only qualify for a partial deduction. For those filing jointly, the upper income limit for the full 20% deduction is $383,900, and for joint filers who earn between $383,900 and $483,900, a partial deduction may apply.
advice: QIB also has a discount of up to 20%, calculated separately, on real estate investment trusts (REITs) and publicly traded partnerships (PTP), but there are some restrictions. In fact, calculating a QBI can be quite complex, so it is recommended to consult with a tax professional.
Management of a limited liability company
Running a business as an LLC can be both rewarding and challenging, but to get the most out of the experience, be sure to take advantage of all the tax savings available. Compared to other business entities, LLCs have the advantage that they are not subject to double taxation, which means that LLCs do not have to pay the type of federal taxes that C corporations pay. Additionally, they have the option of choosing their own tax status (LLC , S corp, or C corp), which can result in more tax benefits.
However, in most cases, LLCs simply file with the IRS as LLCs and reduce their tax burden by taking advantage of the deductions and deferral options available under an LLC structure. Other ways to reduce LLC taxes include putting money into a retirement account, deducting health insurance premiums, and if eligible, taking the QBI deduction for service-oriented businesses.
Finally, it’s worth noting that once an LLC begins to grow and move beyond a sole proprietorship, tax filing and reporting can become more complex and time-consuming. If products are sold across state lines or internationally, for example, it may be worth considering a more robust alternative to tax software like ONESOURCE.
ONESOURCE corporate tax software contains flexible modules for tax planning and preparation, and can automate much of the tax process. It’s also surprisingly affordable. For LLCs with multiple investors, K1-Analyzer can help simplify the process of reporting profits, losses, credits and debits to individual investors. Both options automate the most time-consuming aspects of the tax process, giving business owners peace of mind that their tax returns and reports are accurate, maximizing tax savings and reducing the risk of audits.