How to Use an LLC to Reduce Your Taxes

A Limited Liability Company (LLC) is a formal business structure created by state law that combines the operational ease of a sole proprietorship with the liability protection of a corporation. This structure creates a legal distinction between the business and its owners, called members. This protection means an owner’s personal assets, like a house or savings, are generally shielded from business debts and lawsuits.

An LLC is flexible and can have one or many members, who can be individuals or other companies. While the LLC provides this legal shield, its treatment for tax purposes is not fixed. The main flexibility of an LLC comes from its ability to choose how it will be taxed, a decision separate from its legal structure.

Default LLC Tax Treatment

The Internal Revenue Service (IRS) assigns a default tax status to an LLC based on its number of members, which applies unless the owners choose a different one. The underlying principle is “pass-through taxation,” where the business itself does not pay federal income tax. Instead, profits and losses are passed to the owners to report on their personal tax returns.

For a single-member LLC, the default is to be treated as a sole proprietorship. The owner reports all business income and expenses on Schedule C, “Profit or Loss from Business,” filed with their personal Form 1040. The net profit is subject to both ordinary income tax and self-employment taxes, which cover Social Security and Medicare.

When an LLC has two or more members, the IRS defaults to treating it as a partnership. The LLC must file Form 1065, an informational return, and issue a Schedule K-1 to each member detailing their share of the profits or losses. Members use the Schedule K-1 to report income on their personal returns, and their share of the earnings is also subject to self-employment taxes.

Electing S Corporation Tax Status

An eligible LLC can elect to be taxed as an S Corporation, a choice that can offer significant tax savings. This election does not change the LLC’s legal structure or liability protection; it only alters how its profits are taxed. The primary advantage centers on the treatment of self-employment taxes.

The S Corp election introduces a distinction between salary and distributions. An owner who works in the business must be paid a “reasonable salary” as an employee. This salary is subject to FICA payroll taxes, which are split between the business and the owner. Any remaining profits beyond this salary can be paid out as distributions, which are not subject to self-employment or FICA taxes.

For example, consider an LLC with one owner and $100,000 in net profit. If the owner determines a reasonable salary is $60,000, that amount would be subject to FICA taxes. The remaining $40,000 of profit could then be taken as a distribution. This $40,000 is still subject to ordinary income tax but avoids self-employment taxes, creating a direct financial benefit.

Defining “reasonable compensation” is important, as the IRS requires the salary to be fair for the services provided. The IRS looks at factors like the owner’s duties, time invested, and what comparable businesses pay for similar services. Business owners should document how they arrived at their salary figure.

Electing C Corporation Tax Status

An LLC also has the option to be taxed as a C Corporation, though this is less common. When an LLC makes this election, it forgoes pass-through taxation and is treated as a completely separate taxpayer from its owners. The C Corporation files its own tax return, Form 1120, and pays tax on its profits at the federal corporate rate.

This structure can lead to “double taxation.” The first tax occurs when the corporation earns a profit. The second occurs if the corporation distributes its after-tax profits to owners as dividends, which are then taxed on the owners’ personal returns.

Despite this, the C Corp election can be advantageous for businesses that plan to reinvest a substantial portion of their earnings back into the company. By retaining profits within the corporation, owners can defer the second layer of tax on dividends. This allows the business to use funds for expansion or other investments, with the profits being taxed only at the corporate rate, which may be lower than the owners’ personal income tax rates.

The Qualified Business Income Deduction

Owners of pass-through businesses, including LLCs taxed under their default status or as S Corporations, may be eligible for the Qualified Business Income (QBI) deduction. This benefit, also known as the Section 199A deduction, allows eligible taxpayers to deduct up to 20% of their qualified business income from their taxable income. It is a personal deduction taken on the owner’s Form 1040, not a business deduction.

Qualified business income is the net amount of income, gain, deduction, and loss from a qualified trade or business. For an LLC taxed as a sole proprietorship, this is the net profit from Schedule C. For an LLC taxed as a partnership or S Corp, QBI is passed through to the owners on their Schedule K-1.

The QBI deduction is subject to several limitations based on the owner’s taxable income. Once income exceeds a certain threshold, the deduction may be limited by the amount of W-2 wages paid by the business and the basis of qualified property. These limitations mean that not every business owner will receive the full 20% deduction. Business owners should also be aware that this deduction is scheduled to expire after 2025 unless it is extended by Congress.

Making a Tax Status Election

Once a business owner decides to change the LLC’s default tax treatment, they must file a formal election with the IRS. The process and forms depend on whether the LLC is electing S Corporation or C Corporation status.

To elect S Corporation status, an LLC must file Form 2553, “Election by a Small Business Corporation.” This form requires the LLC’s name, address, Employer Identification Number (EIN), and the consent of all members. For the election to be effective for the current tax year, it must generally be filed within the first two months and 15 days of that tax year.

For an LLC choosing to be taxed as a C Corporation, the required filing is Form 8832, “Entity Classification Election.” This form is used to select a tax status different from the default and has its own timing rules that must be followed. Filing these forms correctly and on time is the necessary step to officially change how an LLC is taxed.