Many people view LLCs as magic wands that can erase taxes. The truth is, just having an LLC could actually make things worse.
What is an LLC?
LLC stands for Limited Liability Company. It’s a special tool under state law that helps business owners protect their personal assets from business debts and losses.
The Internal Revenue Service doesn’t actually recognize LLCs as a business structure for tax purposes. Instead, you have to choose whether you want your Limited Liability Company taxed as a sole proprietorship, partnership, or corporation.
What are the disadvantages of having an LLC?
Let’s start with the disadvantages of having an LLC since they’re simpler. The disadvantages really center around money.
- Most states charge a filing fee to create an LLC
- You may decide you want to hire a lawyer to create your LLC
- Most states charge an annual fee to renew your LLC
- In some states, you may have to pay an LLC tax that’s higher than the tax you would have paid as an unregistered sole proprietorship
So as you can see, you’re already losing money when you’re trying to save money.
What are the advantages of having an LLC?
A lot of the time, someone that wants to charge you to create an LLC lists general tax benefits as LLC tax advantages. Most of the time, so-called LLC tax benefits will be tax benefits that you can get with or without an LLC.
There are certain complex tax situations where an accountant will use an LLC to get more creative. And, of course, if you want to have an LLC for legal reasons, it’s important to know what tax benefits you can use with your LLC.
Ability to Be Taxed as a Corporation
The main reason to create an LLC for tax reasons is to pay income taxes as a corporation. Most people who do this are looking to create an S-corporation for the purpose of reducing self-employment taxes.
You can potentially save a lot of money if you can pay taxes on your business income as an S-corporation. Self-employment taxes are usually 15.3%, so if you can convert some of your income to dividends not subject to self-employment tax, that can be a large savings. (But talk to a tax accountant before choosing S-corporation tax status because there are strict rules about how you can classify your income.)
But you don’t need an LLC to create an S-corporation. You can also choose to form a corporation and elect S-corporation tax status.
An LLC taxed as an S-corporation and a corporation taxed as an S-corporation will generally pay exactly the same amount in taxes. The deciding factors on which one is better are:
- Costs, such as filing fees and legal expenses. Which one costs more can vary by state.
- Any special legal considerations you’ve discussed with your lawyer that makes one business structure better for non-tax reasons.
You do not have to have an LLC or other registered business to claim business expenses. This simply isn’t a rule, even though some people think it is.
Having an LLC also generally doesn’t help you increase your deductions or have an easier time supporting them. (Getting a separate business bank account and/or using accounting software can help support your deductions, but you don’t need an LLC to do those things.)
Who do you think is in better shape?
- A sole proprietor with no LLC who deducts mileage and keeps the required mileage log
- An LLC owner who deducts his entire LLC credit card statement even though he puts personal expenses on the credit card
Having an LLC doesn’t magically turn the money you spend through the LLC into a business expense. The IRS only cares that your tax deductions were for a business purpose, and you can prove that without having an LLC.
Qualified Business Income Deduction
The Qualified Business Income deduction is worth up to 20% of your net profits. As a general rule, you don’t need an LLC to claim the QBI deduction.
You can claim the QBI deduction on your personal income tax return as a Schedule C filer with no LLC.
There may be a very small number of cases where your income is too high to qualify for the full QBI deduction where you might be able to increase your QBI deduction by forming an LLC or other business structure. This would generally only be in complex tax situations where you already have or should have a CPA to discuss this move with.
There are some blogs that say pass-through-taxation or avoiding double taxation are tax advantages of an LLC. Yes and no.
The only time double taxation comes into play is if you’re thinking about using a C-corporation. LLCs will often be better for taxes than C-corporations.
But an unregistered sole proprietorship and non-LLC S-corporation also have pass-through taxation. So while it’s true an LLC does avoid double taxation, you don’t need an LLC to be taxed as a pass-through business.
Deducting Health Insurance Premiums
Another area where you may not need an LLC is health insurance premiums.
If you don’t have an LLC, you may be able to deduct your own health insurance costs under the self-employed health insurance deduction. Premiums you pay for your employees are generally always deductible.
If you have an LLC not taxed as a corporation, the same rules generally apply.
If you have an S-corporation, things get a little more complicated. The corporation can generally deduct your premiums, but you have to include your premiums in your personal income.
C-corporations can usually deduct premiums and not include them in your personal taxable income, but then you’re dealing with double taxation.
Home Office Deduction
The home office deduction is another area where LLCs will often complicate things without additional tax benefits.
If you’re an employee of your LLC taxed as a corporation, you lose the personal home office deduction. Your corporation can typically reimburse you for a home office without it counting it as taxable income, but the reimbursement is generally the same as the home office deduction.
So you’re generally not saving anything with regard to home office expenses if you create an LLC.
LLCs also generally don’t help with deducting business expenses for driving. You can’t claim any additional amount by having an LLC.
If you form a corporation and reimburse yourself for expenses, you can typically only reimburse yourself up to the IRS limits (i.e., standard mileage rate or documented actual expenses). If you reimburse yourself more, you’ll pay taxes on the additional amount.
A sole proprietor can open most small business retirement plans individually, including SEP IRAs and 401(k)s. There is generally no requirement to have an LLC or corporation.
Since a sole proprietor can use both the employee and employer deductions, there’s also generally no benefit to opening an LLC.
What many people think of as LLC tax benefits are often general tax advantages of owning a business. An LLC will almost always cost you money, but it may not save you anything.
It’s worth talking to a tax accountant about possible LLC tax advantages in your specific situation, but you should be aware of your other potential options.