First, a definition. An LLC is a statutorily created form of business entity that combine features of both partnerships and corporations. For more information on the differences between these business entities, please read: Corporation vs. LLC vs. Partnership.
Now, on to LLC Tax Advantages
LLC Tax Advantage: Pass-Through Taxation
LLC’s enjoy pass-through taxation. Here’s how it works: C Corporations are taxed separately from employees, owners, shareholders, etc. So a C corporation suffers what is often termed “double taxation”. That’s an unfortunate misnomer for several rather advanced reasons, but for now we’ll continue to LLCs. Partnerships and LLCs enjoy a counterpoint to double taxation called “pass-through taxation”. All this means is that LLC earnings and profits “pass through” the entity without being taxed–such earnings are only taxed as income to the people or entities that receive such income; however, the LLC is not taxed. Hence the term “pass-through” taxation.
Now, if you operate your business in a state with a high corporation income tax, then LLC pass-through taxation can deliver big savings–all while you enjoy the same traditional personal liability protection of a corporation.
LLC pass-through taxation is the principal taxation difference between LLCs and corporations. But bear in mind that pass-through taxation is a principal feature of S corporations, so to look for differences between S corporations and LLCs, one must look beyond the double taxation question. See our Corporation Law Articles for more information on LLCs and corporations.
LLC Tax Disadvantage: Potentially Higher Self-Employment TaxThis topic gets murky; that’s because congress has some regulations on hold (as of late 2007) that have failed to resolve the issue. This topic gets tricky, so hang on tight:
For corporations (either S corporation or C corporation), a shareholder pays about 15.3% self-employment tax on the first $80,000 of earnings (that’s a rough number), and about 2.9% above that for Medicare. However, self-employment tax only applies to income, and not to *profits* that pass to the owner’s automatically. So, an owner might perform $50,000 of services (and pay self employment tax on that sum), but might get another $75,000 as a profit distribution. The profit distribution is not subject to self-employment tax.
On the other hand, the rules for LLCs are not clear, and some proposed rules to clarify are on hold. In such an instance, the LLC owner might pay a bit more in tax.