There are many reasons why limited liability companies (LLCs) are popular among small business owners, including the fact that LLCs are recognized as "pass-through" entities for federal income tax purposes.
But what is a pass-through entity, what are the benefits, and how does this form of taxation work? Let’s take a look.
What is a pass-through entity?
Pass-through entities are businesses that pass their income directly to their owners, shareholders, or investors. Revenues are taxed only on individuals, not on the entity itself.
Common types of pass-through entities include
How does pass-through taxation for an LLC work?
Pass-through taxation means that an LLC doesn’t file a corporate income tax return with the IRS. Instead, once an LLC has paid its expenses and debts, the LLC owners or members pay tax on any remaining revenue.
Even if you leave profits in the LLC – for instance, to hire new personnel or expand the business – each member must report those profits on their personal income tax returns.
Here’s how pass-through taxation works for single-owner and multiple-owner LLCs:
- Single-owner LLCs: An LLC with one member is typically taxed as a sole proprietorship. Single-owner LLCs must report income and business expenses using Form 1040 Schedule C.
- Multiple-owner LLCs: If the LLC has two or more members, it is taxed as a partnership. Members receive a Schedule K-1 from the LLC, and transfer that information to Part II of Schedule E and any other forms indicated on Schedule K. These forms are then filed with Form 1040. In addition, each owner must file a partnership information return, Form 1065. This form lists how revenue came in and was distributed to the owners. No entity-level taxes are involved.
Note: Don’t confuse IRS tax classification with the type of entity you formed – an LLC is an LLC, whether it is taxed as a sole proprietorship or a partnership.
What are the main benefits of pass-through taxation?
The main benefit of pass-through taxation is that your business entity is not subject to double taxation. Meaning you don’t pay tax twice (at the corporate and personal level) on the same source of income. By comparison, traditional corporations are subject to double taxation.
As an owner of a pass-through entity, you may also be eligible for a qualified business income (QBI) deduction of up to 20%.
Note: Although LLCs are pass-through entities for income tax purposes, they may still be subject to other state taxes, including franchise, sales, and use taxes.
What are the disadvantages of pass-through taxation?
The main disadvantage of pass-through taxation is that, as an owner, you can be taxed on income you didn’t receive. For example, a pass-through entity can’t defer tax on profits that you plan to reinvest in the business at a later date.
Another disadvantage is that, even if you avoid corporate tax, you may be subject to self-employment tax.
Can an LLC be taxed as a corporation?
Yes, you can elect your LLC to be taxed as a corporation (C corporation) by filing Form 8832, Entity Classification Election. In addition, an LLC can elect to be taxed as an S corporation by filing Form 8832, and then Form 2553, Election by a Small Business Corporation.
For more information, see LLC electing S corporation tax status.
Decide on the right business type
If you’re starting a business and not sure whether an LLC (and its associated pass-through taxation benefits) is right for you, use our Business Type Comparison Tool to compare common business types such as an LLC, sole proprietorship, C corporation, and S Corporation.
