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One of the biggest appeals of incorporating as an LLC has long been the ability to save money on taxes. In addition to limited liability protection and building credibility with consumers, forming an LLC allows you to choose between an S corporation and C corporation for your tax entity.
But do you really receive as many breaks with this legal structure as you might with another entity, like a corporation? Let’s break down how the IRS initially taxes an LLC, what it means to make an S corp election on an LLC (or corporation), and a shortlist of items to tackle once you’ve decided to incorporate as an LLC.
How is an LLC initially taxed?
Believe it or not, LLCs still don’t have a specific tax category yet. When entrepreneurs incorporate as an LLC, the IRS taxes the entity as either a sole proprietorship (if there is only one owner) or as a partnership (if there are multiple owners). This means all taxable income directly passes through to the personal tax return(s) of the owner(s), in a process that is referred to as “pass-through taxation.” When this happens, the income is treated as earned income and is subject to employment taxes.
The good news is that your business doesn’t have to be taxed as a sole proprietorship or partnership. You can elect to be taxed as a corporation or make an S corp election instead, which is covered more in-depth below.
How do you make an S corp election?
Entrepreneurs may not realize that both LLCs and corporations can make an S corp election. For LLCs, this requires applying for an employer identification number (EIN) with Form SS-4 and filing Form 2553 Election By a Small Business Corporation.
Taxable income for an LLC, once compensation and business expenses have been deducted, is reported as passive income instead of earned income. Once LLCs have qualified for the S corp election, they will need to file Form 1120S U.S. Income Tax Return for an S Corporation. Corporations may also make an S corp election by filing Form 2553.
How do I know if an LLC will provide me with the best tax breaks?
Aside from being able to choose your tax entity, incorporating as an LLC also provides FICA tax savings and standard write-offs. However, only a tax professional will be able to tell you what would truly be best for your business. It is advisable to meet with a tax professional first to discuss your options and ask any questions you may have about the process.
If you do decide to incorporate as an LLC, make sure you do everything necessary afterwards to keep your business in compliance. Draft an operating agreement, obtain an employer identification number (EIN), register any trademarks you might have, apply for business licenses and doing business as names (DBAs), and stay on top of your annual maintenance by filing annual reports.