Small Business Tax Loopholes: 3 Things to Consider for Your LLC

When Do I Have to Choose a Tax Election?

After forming an LLC, there are three alternative tax regimes. No action is required for the first one, and the other two tax elections can be elected if you think either of the S or C corporation tax elections may be more favorable for your LLC. The right to make these IRS tax elections for your LLC is known as the “check the box” regulation.

Do not delay formation due to tax decisions. The sooner you form your LLC, the sooner the protective limited liability shield is created. You can wait up to 75 days to decide on your tax elections which can reduce your effective tax rate.

Default Tax Treatment of LLCs: Easy, But Not Usually Most Favorable

For example, if an LLC begins with one member it will be taxed as a sole proprietorship, meaning all income and expenses are reported on Schedule C of the individual’s tax return. This is known as a disregarded entity for tax purposes because the income and expenses are reported on the single member’s personal 1040 U.S. Tax Return and not a separate business tax return.

Multi-member LLCs default to partnership tax status and therefore file IRS Form 1065 Partnership Return with a Form K-1 for each individual member listing both the income and losses to be reported by each member of the partnership. The primary detriment to being taxed as a sole proprietorship or partnership is that all taxable income is subject to employment taxes as “earned income,” meaning that a 15.3% Social Security-Medicare tax applies to all income up to $90,000, and a 2.9% Medicare rate applies to any subsequent income above that.

LLCs Reduce Self-Employment Taxes with S-Election

If an LLC wishes to avoid up to half of the Social Security and Medicare contributions, the LLC may make a Subchapter “S” election by applying for an EIN on form SS-4 and filing the IRS Form 2553 within 75 days of formation or the beginning of a tax year. Only U.S. citizens or green card holders may be members of an LLC which elects Subchapter “S.” After making the S-election, up to half of the LLC’s taxable income may be left in the LLC instead of paid out as compensation. Instead it will be distributed or  reported as passive income, known as an S-Dividend, not subject to Social Security contributions. Following the “S” election, the LLC is required to file IRS Form 1120S Corporation Income Tax Return each year.

The taxable income is passed through pro-rata to the LLC members based on the percentage ownership of the members of an LLC electing to be an S-Corporation. Each member is sent a Form K-1 at the end of each year listing the taxable income to be reported by that member. The LLC incurs no income tax. The S-Corporation tax return, IRS Form 1120S, is only an informational return.

LLC Making C-Corporation Election: 15% Tax Rate

As a second alternative, the LLC may elect to be taxed as a C-Corporation. This is how an LLC can achieve a 15% tax rate. The LLC can make this election by filing the C-Corporation election on IRS Form 8832 within 75 days of either the formation date or the beginning of a subsequent tax year. Taxable income is taxed at corporation rates and reported on the IRS Form 1120 Corporation Tax Return to be filed each year. The tax rate on LLCs electing to be taxed as C-Corporations is 15% on the first $50,000 of taxable income each year.

LLCs electing C-status which render personal services are not eligible for this low tax rate unless the ownership is structured so that at least 6% of ownership interest belongs to somebody not employed by the corporation or LLC (which may include spouses or relatives) in order to avoid the Personal Service Classification. Unless you are a professional who is not eligible for this exception, this loophole in the U.S. tax law may be used to save thousands in taxes.

The funds left after paying this low 15% rate may be retained to use as working capital, distributed out to the owners through dividends, or lent out. The owner can also borrow up to $10,000 from the corporation using an interest-free promissory note. Interest must be paid at the applicable federal rate or it will be imputed on any loans from the corporation in excess of $10,000.

Other Small Business Tax Loopholes

After you form your LLC, you have up to 75 days to make one of two tax elections, or else you will be taxed as a sole proprietorship for a Single Member LLC, partnership or partnership for a Multi-Member LLC. This deduction can reduce your overall tax burden depending on your business structure and income level.

The most common option is pass-through taxation, known as a disregarded entity, where profits are reported on the owner’s personal tax return IRS Form 1040 Schedule C. This avoids double taxation and is often the simplest setup for small businesses. It is only available for Single Member LLCs. The disadvantage of this tax status is 100% of the income is subject to self-employment tax, known as FICA or Medicaid taxes. Nevertheless, many people prefer this tax status, especially for real estate and passive asset ownership.

Note that a multi-member LLC would not be eligible for this sole-proprietorship simplicity. Every LLC with two or more members, even if husband and wife filing jointly, must file as a partnership on IRS Form 1065, where each owner gets a K-1 for their share of profits and losses. One unique advantage of the partnership tax status is the ability to distribute profits and losses disproportionately to ownership. That way the members can agree that all tax losses go to one member who could use the losses, such as an investor. This is also good for non-citizen owners and owners who are other entities not eligible for the S-election.

Another option is electing S corporation status, which may allow owners to split income between salary and distributions and potentially reduce self-employment taxes, though it comes with payroll and compliance requirements.

A third option is C corporation taxation, which may benefit businesses that plan to reinvest earnings or experience losses in early years because of large capital investments. While subject to corporate tax, it can offer more flexibility for certain growth strategies.

Each option has tradeoffs, so it is often best to work with a CPA experienced in small business to help make the best decision.

The Takeaway: Form the LLC First, Consider the Tax Elections Second

The first step is to form your LLC. Once your business is set up, you can evaluate for up to 75 days the best LLC tax strategy based on how it operates and earns income.

By default, LLCs are taxed as pass-through entities, but you may later elect S corporation or C corporation status within 75 days of formation or within 75 days of a subsequent calendar year.

LLC tax elections are always made after formation. Many business owners consult a CPA or tax professional to help choose the right structure.

In most cases, the best approach is simple: form the LLC first, then decide on tax elections under the IRS “Check-the box” rules.