Best way for an LLC to be taxed

What is the best way for an LLC to be taxed?

Seems like a simple question, right? The truth is it is not that simple.

By best way, I assume you mean the way resulting in the least amount of tax being owed. Unfortunately there is no one size fits all answer when it comes to LLC taxation.

LLC’s are very flexible when it comes to US federal taxation with basically 3 options of how the LLC is viewed for federal taxes. All three ways have pros and cons.

  1. Passthrough taxation-Either a sole proprietor for a single member LLC or partnership for a multi-member LLC. Pros-pretty straight forward simple taxation. The LLC is essentially disregarded for tax purposes. A single member LLC is by default called a “disregarded entity”.  All the income and expense of the LLC flows through to the owner(s). The income is taxed on the owner(s) personal tax return. Assuming the business and taxpayer otherwise qualify you also get the 20% QBI tax deduction in calculating taxable income. Owners are also generally free to take money out of the business as needed. Cons-Probably the biggest is 15.3% self employment tax which is added to other income tax. SE tax is based on net profits from the business.
  2. S-Corporation taxation-Can work for single or multi-member LLC’s. Pros-Many of the same benefits of passthrough taxation that you get with a partnership. Added advantage that with the right set of facts, you can avoid some of the self employment tax you are subject to with a sole proprietor/partnership. Cons-mostly the added complexity of S Corporation. Owners must be paid a W2 wage from the business, which means quarterly payroll taxes and annual W2 reporting. Limited as to the types and number of shareholders that can own an S Corp. Non-wage distributions from an S Corp must be proportionate to the ownership percentages. You will need somewhat more advanced bookkeeping as you need to keep track of a profit and loss and balance sheet for the business.
  3. C-Corporation taxation-Can also works for single or multi-member LLC’s. Pros-separates the owners and the business for tax purposes, which can be an advantage, especially if you have non-US owners. The business pays a flat 21% corporate tax rate. Cons-risk of double taxation on dividends. Limitation that owners can only take money out of the business as compensation or dividends. Similar W2 and bookkeeping requirements as with an S Corp above.

Deciding which way is best for your specific LLC, probably requires a conversation with your CPA to consider your unique set of facts.

One final caution I offer is the structure that results in lower tax is not always the best answer for you, because some of the business structures discussed above require the discipline to actually act like a “grown up” business. For example you can’t just run an S Corp out of your back pocket like you often can a sole proprietorship or you will ultimately get yourself in more trouble than what little tax you might have saved would pay for. I have seen it happen too many times from people who wanted a simple how can I pay the lowest tax answer, but then did not want to do the actual heaving lifting of following the tax laws so that the business structure worked for them.

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