LLC Tax Pros and Cons for Small Business Owners
Many entrepreneurs consider forming a limited liability company because this type of entity may offer flexibility, potential tax advantages, and protection for personal assets under certain circumstances. The step of choosing the right business structure is one of the first major decisions new owners may face. Even established businesses may periodically reevaluate whether their current setup still aligns with their financial goals.
Join the small business accounting team from C.E. Thorn, CPA, PLLC as we take a closer look at the advantages of an LLC as well as the potential drawbacks.
Table of Contents
What Is a Limited Liability Company (LLC)?
A limited liability company, or LLC, is a business structure that creates a separate legal entity from its owners. This setup may help protect an owner’s personal assets from certain business debts or legal claims, though the level of limited liability depends on proper documentation, operations, and state requirements.
Unlike a sole proprietorship, where the owner is personally liable, an LLC generally keeps business assets and individual assets separate. LLCs may have one member or multiple members, and owners can choose a member-managed or manager-managed structure, depending on what is best for the specific business. Most LLCs are relatively simple to form by filing articles of organization and naming a registered agent.
Advantages of an LLC Business Structure
Understanding the advantages of an LLC can help business owners compare this business structure to a sole proprietorship or corporation. While every situation is different, an LLC may offer flexibility, potential tax benefits, and various forms of limited liability that appeal to both new and growing businesses.
How the IRS Classifies and Taxes an LLC
An LLC’s tax treatment is one of the features that makes this business structure unique. For federal government purposes, most LLCs are classified as pass through entities, meaning the business itself generally does not pay income tax. Instead, profits and losses flow through to the owners’ personal returns and are taxed as part of their individual income. However, LLC owners may elect a different tax classification—such as corporate or S corporation treatment—if it is more appropriate for their situation.
Benefits of Pass-Through Taxation for LLC Owners
Pass-through taxation may offer several benefits depending on income levels, deductions, and how the business structure is maintained. Here are some potential advantages:
Avoids Double Taxation
Profits are not taxed at both the entity level and the owner level, unlike a corporation or c corp where corporate taxes and shareholder taxes may both apply.
Losses May Offset Personal Income
If allowed, business losses may help reduce the owner’s overall tax burden, depending on IRS rules and limitations.
Flexible Profit Distribution:
LLC members can allocate profits according to their operating agreement, which may provide tax planning advantages.
Simplified Filing for Many Small Business Owners
Many small business owners prefer this model because it avoids complex corporate filing requirements at the federal level.
Potential Access to Qualified Business Income Benefits
Some owners may be eligible for deductions on qualified business income, reducing overall taxable income when permitted.
More Transparency In Reporting
Owners see the direct impact of company profits, helping them make informed choices about expenses, payroll, and long-term financial planning.
Income Taxed Once at the Individual Level
Earnings flow to the owner’s return, where they are taxed as personal income, simplifying how members report income tax.
Potential Tax Advantages for LLC Owners
The LLC structure may provide several potential tax-related benefits depending on income levels, elections made, and how the business operates under state law. These advantages vary by owner, but they illustrate why many small businesses consider this flexible entity type.
Reduce Self-Employment Taxes
Some LLC owners elect s-corporation treatment to help manage self employment taxes. A reasonable salary is taxed for Social Security and Medicare, while remaining profits may avoid full self-employment assessment. This can reduce the overall tax burden when the corp status is appropriate for the business.
Eligibility for QBI Deductions
Certain LLC owners may qualify for deductions on qualified business income (QBI), potentially lowering personal income tax when allowed. Because this applies to many pass through entities, it can reduce taxable income on owners personal income. Eligibility varies based on IRS limits and industry type.
No Corporate-Level Federal Income Taxes
Under default classification, an LLC does not pay federal corporate taxes like a c-corporation. Profits pass through to members and are reported on their personal income tax returns, helping avoid double taxation. Owners still must pay taxes on their share of earnings, even if profits remain in the business.
Flexible Allocation of Profits Among Members
LLCs may allocate profits and losses in ways that reflect contributions or goals outlined in the operating agreement. This flexibility can benefit members with differing membership interests or involvement levels. Unlike partnership structures with general partners, members maintain limited liability while customizing allocations.
Ability to Choose a Different Tax Classification
LLCs can elect to be taxed as a disregarded entity, partnership, c corp, or s corps, depending on what suits long-term plans. This flexibility may support growth, changes in revenue, or strategies for raising capital. The ability to shift tax treatment is a unique advantage compared to other more rigid business entities.
Simplified Reporting for Federal Tax Purposes
Many LLCs experience simpler reporting obligations than a traditional corporation. This may make it easier for owners to track income, deductions, and business assets when preparing personal income tax filings. Streamlined requirements often appeal to small business owners seeking predictable compliance.
Disadvantages and Limitations of LLC Taxation
Although the advantages of an LLC may appeal to many business owners, there are also drawbacks to consider, especially related to self-employment rules, administrative duties, and income reporting.
Self-Employment Taxes
LLC owners are typically considered self employed for tax purposes. This means they must pay self employment taxes on income they receive, which includes both Social Security and Medicare assessments. For some owners, self employment taxes may increase the overall tax burden, especially when compared with certain corporation structures.
Immediate Profit Recognition
LLC members generally report their share of profits for the year they are earned, regardless of whether the company's assets are distributed. This means owners may pay self employment taxes and income tax on funds they did not actually withdraw.
Difficulty Raising Capital
Businesses seeking investments from venture capitalists, limited partners, or large equity groups may find that an LLC is not the preferred structure. Investors often find a corporation easier to work with when raising capital, issuing stock, or planning long-term growth.
Operational Costs and Compliance
LLCs may also experience added operational costs, such as fees associated with maintaining a registered agent, renewing filings, or preparing an operating agreement. While not always significant, these expenses can influence whether an LLC is the best choice for a specific business.
Contact Our Small Business Tax Consultants Today
If you’re a small business owner seeking ongoing accounting assistance, tax planning and prep, or
financial statement preparation services, C.E. Thorn, CPA, PLLC may be able to help.
To see whether we are a good fit for your accounting needs, call us at 919-420-0092 or fill out our contact form to get started.
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