LLC Tax Deductions andBusiness Tax Loopholes
One reason to incorporate is to save on taxes. It is helpful to know in advance how to structure your business to avoid paying higher effective tax rates than necessary with your Corporation or LLC.
Below is a summary of tax deductions, advantages, and loopholes to help you legally lower your effective tax rate compared with being a sole proprietor. These Corporation and LLC tax tips and benefits will help you decide which tax election is right for your business.
*Updated for 2017 Tax Cuts and Jobs Act
Introduction to Tax and Legal Benefits of LLC and Corporation
This roadmap is designed to provide entrepreneurs with information about the legal, tax, and accounting aspects of forming and managing a company.
Listed below are a few important highlights from this Tax and Legal Tips roadmap. Click on the [Learn More] links to read more about these points (in later sections of this page), or scroll down to learn about other tax tips.
LLC and Corporation Entities
- A Limited Liability Company (LLC) is taxed as a partnership (more than one owner) or sole proprietorship (one owner), unless the owners elect to be taxed as a Corporation.
- The unit owners of an LLC or stockholders of a “C” Corporation may be Corporations or foreign citizens.
LLC Tax Benefits and “C” Corporation Tax Benefits
- “C” Corporations (i.e., general Corporations that don’t make “S” Elections or LLCs that elect “C” Corporation tax status) pay a 21% federal tax rate on all taxable income. For tax years beginning after December 31, 2017, the same 21% federal tax rate applies to the taxable income of Personal Service Corporations (i.e. owned by consultants or professionals).
A general Corporation making a Subchapter “S” Election or an LLC with or without a Subchapter S Election pays no federal tax on its taxable income and no employment taxes on its distributions to stockholders. The stockholders of a Subchapter S Corporation and stockholders of an LLC are taxable on their pro rata share of the taxable income of a Subchapter S Corporation or an LLC reported to them on a Form K-1 whether or not the taxable income is distributed. This is referred to as “passed through business income” which up to 20% may be deducted for tax years 2018 through 2025 subject to the limitations in the Tax Cuts and Jobs Act. The deduction may be taken whether or not the individual taxpayer claims deductions or takes the standard deduction.
- Choosing Between an LLC and a Corporation
The “Limited Liability” of Both Entities
The owners of a sole proprietorship or general partners of a partnership are not protected from the judgments against and liabilities of the business or from the acts of their business partners.
The stockholders of Corporations and members owning units in Limited Liability Companies (LLCs), on the other hand, benefit from “limited liability.” In other words, their liability is limited to their investment in the stock of the Corporation or in the units of the LLC.
Why Choose an LLC? – Tax Advantages of LLC
An LLC gives the greatest tax flexibility. The LLC operating agreement includes management provisions and buy-sell provisions, making the LLC a popular entity to own real estate, boats, and airplane, and a popular entity for foreign citizens to render services or sell products.
A one-member LLC starts out being taxed as a sole proprietorship. All income and expenses “pass through” to be reported on schedule C of the individual tax return of the member. No EIN (Employer Identification Number) is necessary.
A multi-member LLC starts out being taxed as a partnership that needs to apply for an EIN on Form SS-4. Each year, a Form 1065 Partnership Return needs to be filed with a Form K-1 for each member listing the income or losses to be reported by each member.
The main disadvantage for owners of an LLC that is taxed as a sole proprietorship or partnership is that all taxable income, which passes through to the owners, is treated as “earned income” and is subject to employment taxes. Therefore, the 15.3% Social Security-Medicare rate applies to the first $128,400 of earned income in 2018 and the 2.9% Medicare rate applies to all earned income in 2018 over $128,400.
To avoid this disadvantage, an LLC can make a Subchapter “S” Election by applying for an EIN on Form SS-4 and filing a Form 2553 within 75 days after the date of formation or beginning of a tax year. (Note: only U.S. citizens and U.S. permanent residents can make this election). After deducting reasonable compensation and other business expenses, the LLC’s taxable income is then reported by the member(s) as passive income, rather than earned income subject to Social Security and Medicare contributions. After making the “S” election, the LLC would need to file a Form 1120S Corporation Income Tax Return each year.
An LLC may elect to be taxed as a Corporation (a.k.a. “C” Corporation) by applying for an EIN, and then filing a Form 8832 within 75 days after the date of formation or beginning of a tax year. After deducting reasonable compensation and other business expenses, the taxable income of an LLC electing “C” Corporation tax status is taxed at the Corporation tax rates on a Form 1120 Corporation Tax Return to be filed each year. For tax years beginning after December 31, 2017, a permanent change was made in the Corporation to a flat tax rate of 21% on all taxable income. Corporation
Why Choose a Corporation? Simple Corporation Tax & Legal Explanation
A Corporation is controlled by a majority of its stockholders. A Corporation needs to obtain an Employer Identification Number (EIN) and file a U.S. Corporation Income Tax Return each year.
A Corporation starts out as a “C” Corporation for tax purposes. This means that the taxable income (after deductions for salary, business expenses, and depreciation on furniture and equipment) is taxable to the Corporation. The Corporation would only be taxed on income “effectively connected with the United States.” The flat 21% corporate tax rate then applies to the taxable income of the Corporation regardless of its activity. Previously the taxable income of personal service Corporations was taxed at the highest personal tax rate.
Subchapter “S” Corporation
A Corporation owned by one or more U.S. citizens or permanent residents may file a Subchapter “S” Election with the Internal Revenue Service on Form 2553 within 75 days after either the date of incorporation or the beginning of a year. The “S” Election will cause the taxable income of the Corporation to be passed through to be taxed to the Corporation’s stockholders in proportion to their stock ownership.
The advantage of the “S” Election for Corporations that render personal services is that the profits distributed as “S” Corporation dividends are treated as passive income, and therefore, not subject to employment taxes. After reasonable salaries are paid for the personal services, the 12.4% Social Security Tax and 2.9% Medicare Tax would not have to be paid on the “S” Corporation’s dividends.
The disadvantage of the “S” Election is that deductions for health insurance, disability insurance, automobile, and medical, drug and dental plan reimbursements would be taxable to the “S” Corporation stockholders for whom they are paid.
Lowering the Tax Rate
- Tax Benefits of LLC and Corporation
The Corporation or LLC which elects to be taxed as a Corporation can be a tax shelter because the tax on its taxable income is limited to 21%. A Corporation or an LLC that elects “C” Corporation tax status can retain up to $250,000 without having to justify (and pay a higher tax rate on) its accumulated earnings.
The accumulated after tax profits can be used to pay off corporate debt or for working capital to operate or grow the business instead of opening a Line of Credit loan.
The taxable “C” Corporation tax status can also be used for income averaging because Net Operating Losses can be carried back to two previous years and carried over to future years.
Allowable Tax Deductions
- Charitable Deductions
Since a Corporation or taxable-LLC can only deduct charitable contributions up to a value of 10% of its taxable income, it is usually advisable for the owner to make personal charitable contributions. (Note: Any excess Corporation or LLC charitable deductions not currently deductible can be carried over for 5 years).
- LLC and Corporation Health Insurance Deductions
A “C” Corporation or taxable-LLC can deduct all of the premiums paid on health insurance for its owners who are employed, along with their spouses and dependents. The cost of the premiums is not taxable to the employee owner. Subject to the rules of the health insurance company, health insurance might not be provided to other employees, or might be limited to single coverage. If family health insurance coverage costs $5,000 per year, the owner might have to earn twice that amount (in pre-tax dollars) to net enough to pay the premium out of his or her personal funds (in after-tax dollars). An individual can only deduct the premiums if the total of premiums and other medical deductions does not exceed 10% of the individual’s adjusted gross income
- LLC and Corporation Disability Insurance Deductions
A “C” Corporation or taxable-LLC can purchase disability insurance for one or more of its executives or other employees, and deduct the premium without the cost being taxable to the executive or employee. The drawback is that the benefits will be taxable when they are received by the disabled executive or employee. In order to avoid taxation on the benefits, the executive or employee should purchase and pay the premiums on the disability insurance. After the end of each disability contract year, the “C” Corporation or taxable-LLC could reimburse the executive or employee for the premium and take a deduction for the reimbursement.
- LLC and Corporation Business Automobile Deductions
The “C” Corporation or taxable-LLC could reimburse an executive or employee the current mileage rate permitted by the Internal Revenue Service for the business use of an automobile owned by the executive or employee. Another alternative is that the “C” Corporation or taxable-LLC could purchase or lease a business automobile and include a percentage of personal use of the automobile, including trips to and from the office, in the Form W-2 of the executive or employee. The Tax Cuts and Jobs Act substantially increased the deduction over the first three years to $35,000. A third alternative is that the executive or employee could purchase the automobile, take depreciation on it up to the business percentage use, and lease it to the business. The advantage of this approach is that you don’t have the valuation question if the executive or employee wants to get the automobile out of the Corporation or taxable-LLC for personal use when it is to be replaced by a new business automobile.
- LLC and Corporation Business Insurance Deductions
You should consult with your insurance agent to determine the various types of insurance coverage you will need for your Corporation or LLC. The Corporation or LLC should be listed as the name insured on all of the insurance policies. You should make certain that Workmen’s Compensation Insurance covers all individuals who are employed by the Corporation or LLC. If you are a consultant, the Corporation or LLC may want to purchase professional liability insurance. The individual owners who are employed by the Corporation or LLC should consider purchasing an umbrella liability insurance policy with coverage of no less than $1 million to raise the coverage limits of their automobile and homeowner’s policies. The premiums for the foregoing insurance are deductible by the Corporation or taxable-LLC.
- LLC and Corporation Office at Home Deductions
The Internal Revenue Code has been liberalized to allow a Corporation or taxable-LLC to reimburse its employees for their office at home expense, so long as the office at home is used regularly and exclusively for administrative and management activities of the business, and/or for storing records, inventory, or product supplies. The reimbursement could be paid on a monthly or yearly basis, is deductible by the Corporation or taxable-LLC, and is not included in the income of the employee. The items that can be included in the office at home calculation are: homeowner insurance, cleaning, maintenance, utilities, and telephone. The reimbursement is based on the percentage of office at home space in relation to the overall space in the home. The IRS allows an office at home reimbursement up to $1500 without having to itemize expenses which is pro-rated up to the use of 300 square feet for the office at home. Although depreciation could be taken on the office at home space, it would be recaptured upon the sale of the home. In order not to lose any of the long term capital gain exclusion ($500,000 for married couples and $250,000 for single tax payers), it is advisable to not take the office at home reimbursement during the last three years before your home is sold.
- LLC and Corporation Tangible Property (Section 179) Deductions
Section 179 of the Internal Revenue Code permits the deduction of up to $1 Million (in the year of purchase) of the cost of tangible personal property to be used in the business. Computers, off-the-shelf computer software, and office furnishings all qualify as Section 179 property. The Tax Cuts and Jobs Act added the cost of roofs, HVAC, fire protection, alarm and security system in nonresidential real property to the allowable Section 179 deductions. Since there is an advantage Since there is an advantage to offsetting the cost of Section 179 tangible property against income in the year of purchase, you could plan to stagger your purchases in different tax years of the business.
- LLC and Corporation Retirement Plan Deductions
A Corporation or LLC can deduct contributions to qualified retirement plans. There are a lot of choices for qualified plans with different deduction limits that can be adopted. Plans can be adopted that provide for immediate vesting or provide for staggered vesting of the participant’s account. The contributions to the qualified plans accumulate tax-free in the plan until distribution to the employees upon death, disability, or retirement (when it is then subject to income tax). If an employee changes jobs, he or she can do an income-tax-free rollover of his or her vested interest to the plan of another employer or to a Rollover IRA account.
- Children as Tax Shelters
The minor children of business owners can be paid for working for the business after school or during vacations. In effect, they can earn tax-free allowances or save for education. A child for whom a dependency exemption is allowed to another taxpayer may earn up to $6,350 without having to file a tax return. Even though Social Security contributions have to be made while children are employed by a Corporation or LLC, a Form W4E exemption from withholding tax can be filed. The child can also contribute up to $5,500 of his or her earned income to an IRA or Roth IRA.
- LLC and Corporation Business Entertainment and Meals Deductions
A Corporation or LLC can deduct up to 50% of the cost of meals consumed during times of business entertainment or professional development. The cost of meals with employees is 100% deductible.
- LLC and Corporation Education Expense Deductions
A Corporation or LLC can deduct education expenses (currently limited to $5,250) of its employees for them to maintain or improve their skills. The reimbursement for education expense under the employer’s education assistance program is not included in the income of the employee.
- LLC and Corporation Longevity or Productivity Awards Deductions
A Corporation or taxable-LLC can deduct up to $400 of the cost of tangible property given to an employee by declaring it a longevity or productivity award. The award can be made every 5 years on a selective basis, with possible recipients including the owners who are employed by the business. The cost of the award is not included in the income of the recipient. The Tax Cuts and Jobs Act specifically excludes awards of nontangible items such as cash, gift cards, vacations, meals or tickets.
- LLC and Corporation Dues and Subscriptions Deductions
A Corporation or taxable-LLC can deduct the cost of dues for business or professional organizations and/or the cost of newspapers and subscriptions related to the business. The cost is not included in the income of the employees who benefit from them. A sole proprietor could only deduct his or her expenses to the extent that the cost exceeds 2% of the sole proprietor’s adjusted gross income.
- LLC and Corporation Conventions and Continuing Education Deductions
A Corporation or LLC can deduct the cost of travel, lodging, meals, and program fees for employees attending conventions and continuing education. This includes one or more owners employed by the business. The reimbursement is not included in the income of the employee.
- LLC and Corporation Independent Contractor Agreement
If a consultant or manufacturer’s representative forms a Corporation or LLC through which to receive his or her income, it is important for the Corporation or LLC to execute an agreement with the client or manufacturer stipulating that the Corporation or LLC is an independent contractor providing the services of the consultant and is to be paid directly without any employment taxes or withholding. It is not unusual for a retired executive to form a Corporation or LLC to consult for the former employer on special projects or other clients in order to get the tax advantages of a Corporation or taxable-LLC.
Other Financial Considerations
- Electing a Fiscal Year by Corporation or Taxable LLC
A “C” Corporation or taxable-LLC can elect a fiscal year that will straddle the individual income tax year of December 31. Therefore, the income of a Corporation or taxable-LLC before December 31 can be deducted when it is paid as compensation after December 31 but before the end of the fiscal year of the Corporation or taxable-LLC. A fiscal year can end at the end of any month within twelve months after the month in which the Corporation or LLC was formed. The fiscal year election is made on the Corporation tax return, which is due to be filed within 2.5 months after the end of the first fiscal year. (Note: The fiscal year of an “S” Corporation or an LLC that does not elect to be taxed as a Corporation will end December 31 each year after it is formed).
- Interest-Free or Low-Interest Loans from LLC or Corporation
The accumulated earnings of a “C” Corporation or taxable-LLC can be lent to the owners of the Corporation or limited liability company. A loan of up to $10,000 can be made without interest to each owner. Minimum interest, such as 6%, should be paid on the entire loan if the loan exceeds $10,000. If a “C” Corporation or taxable-LLC needs working capital, the owner could make loans to the Corporation or taxable-LLC after the initial capital contribution. (Note: Under Delaware, Florida, and Nevada laws, there is no minimum capital contribution to a Corporation or limited liability company). The advantage is that the loans can be repaid out of Corporation or taxable-LLC earnings accumulated at the low 21% corporate or LLC tax rate. This avoids the money being locked in the Corporation or LLC as a capital contribution until the Corporation or LLC is liquidated. In order for the repayment of a loan from owners to not be considered a dividend by the Internal Revenue Service, it should not exceed 5 to 10 times the amount of capital contributed by the owners (i.e. debt to equity ratio). Loans should always be documented with Promissory Notes.
Other LLC and Corporation Operating Considerations
- Accounts Receivable and Accounts Payable
A Corporation or LLC cannot be used until it is formed. However, Section 351 of the Internal Revenue Code permits the assignment of all the accounts receivable and accounts payable of a business to a newly formed Corporation or LLC so that they can be collected and paid through the Corporation or LLC.
- LLC and Corporation Signature Block
In order to preserve the limited liability of the Corporation/LLC owner, all business documents and contracts should be executed in the name of the Corporation or LLC using the following form of signature block:
Corporation or LLC Name
Corporation President or LLC Managing Member Name
- LLC and Corporation Licenses
A Corporation or LLC should apply for and maintain the required business licenses in the city, county, and/or state where it does business.
- LLC or Corporation Qualification in Other States or Countries
If a Delaware, Florida, or Nevada Corporation or LLC does business, has an office, or hires employees in other states or countries, it may have to qualify to do business in those other states or countries. Usually, a Certificate of Good Standing is required by the state, or an Apostille is required by some foreign countries. (Incnow can provide these documents).
- LLC or Corporation Preservation of Name or Trademark
The availability of a name in Delaware, Florida, or Nevada for a Corporation or LLC does not mean it is available for use in other states. It also does not mean that it has not been trademarked or reserved as a domain name in internet commerce. Separate searches need to be done to determine whether any conflicts exist.
- LLC or Corporation Address and Bank or Merchant Accounts
A Delaware, Florida, or Nevada Corporation or LLC does not have to use a Delaware, Florida, or Nevada business address or a Delaware, Florida, or Nevada bank account. If you want a Delaware, Florida, or Nevada mailing address for mail forwarding or want to open a Bank or Merchant account, please call Incnow for a recommendation.
- Corporation Annual Meeting
A Delaware, Florida, or Nevada Corporation is supposed to have on Annual Meeting of its directors and stockholders. This meeting can be held outside of Delaware, Florida, or Nevada. By unanimous consent, the minutes can be signed without a meeting. The main purpose of the meeting is to elect or re-elect the officers and directors. LLC’s are not required to have annual meetings.
Revised February 14, 2018
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