Tax Efficiency: How Small Businesses Benefit from Forming an LLC

When you start a small business, you’re typically excited about things like developing a product, assembling a team, and cultivating a loyal base of customers. Often, tax planning is one of the furthest things from your mind. And yet, an efficient tax strategy can be essential for maximizing your business’ profitability. It’s never too early to think critically about taxes.

One of the most practical ways to boost tax efficiency is to choose the right legal structure for your business. For most small businesses, this means registering as a Limited Liability Company, aka LLC.

What is an LLC?

The LLC entity has been around since the 1970s. It has become the most popular option among business owners, spanning virtually all industries and verticals.

The important thing to remember is that any time you start generating income on the basis of self-employment, the government automatically considers you to be a Sole Proprietor (aka Sole Proprietorship).

 Operating a business as a Sole Proprietorship is not a distinct legal entity. This means there is no separation between your assets and liabilities, and the company’s. So, if your business is sued, it's essentially you being sued – and your personal assets could be at risk.

That’s a big part of why so many small business owners have gravitated toward the LLC format. When you register an LLC, you actually create a separate legal entity. This allows you to maintain a line of separation between personal and business finances and to ensure your personal wealth is safeguarded.

Personal wealth protection is the most common reason entrepreneurs seek out LLC registration, yet there are several other significant benefits. One of the primary benefits is tax efficiency.

How Do LLCs Pay Taxes?

As for how LLCs pay taxes, the short answer is… it varies. The default position for an LLC is to pay taxes on a pass-through basis. However, some LLCs opt into corporate taxation if they believe that it is the best option for their overall tax strategy.

Pass-Through Taxation

What does it mean to pay taxes on a pass-through basis?

Assuming you have a Single-Member LLC, it means you declare your profits or losses on your personal tax return. Your LLC doesn't also pay taxes. If your business was profitable, you’ll pay taxes at your normal personal income tax rate.

For Multi-Member LLCs, the situation is more complicated, though not by a lot. Basically, if you have multiple partners, you should also have an Operating Agreement in place. This document specifies duties and responsibilities at your LLC, but it can also outline a profit-sharing agreement.

Each partner will then report profits or losses on their personal tax return (they'll get a K-1 from the LLC, which reflects this amount) according to the percentage allocated to them in the Operating Agreement. They will then pay taxes at their normal personal income tax rate.

What this means is that different members may owe the government different amounts. This could be due to varied profit allocations; for example, one member may claim 60 percent, the other 40 percent. It may also be because different partners are in different personal income tax brackets, meaning their rates will not be the same.

In addition to the members paying taxes on their personal tax return, the LLC will also need to file an "informational return" called a 1065 Partnership Return. 

Corporate Taxation

LLCs can also elect to be taxed as a Corporation. There are two types of corporate taxation:

• LLC taxed as an S-Corporation
• LLC taxed as a C-Corporation

Taxing your LLC as an S-Corporation can save money on self-employment taxes; however, it comes with extra administrative costs and bookkeeping responsibilities. For example, setting up payroll and filing regular payroll returns.

Having an LLC tax a C-Corporation is another option; however, this is much more rare and has more disadvantages for most (namely double taxation). This tax election – if used – is typically used by big businesses with large healthcare expenses.

You'll want to speak with an accountant if you're interested in S-Corporation taxation to ensure the business has enough net profit to justify the extra expenses. We typically recommend $70,000 of net income, per LLC member before the S-Corp taxation has many savings benefits.

LLC-Specific Taxes

A common question from entrepreneurs: Are there any taxes specific to LLCs? In other words, are there taxes you’ll have to pay as an LLC that you wouldn’t have to pay as a Sole Proprietorship (or in a General Partnership)?

Generally, the answer is no. This applies to LLCs with default tax election (Single-Member LLCs taxed as Sole Proprietorships and Multi-Member LLCs taxed as Partnerships). You pay the same amount of taxes with or without an LLC. The only difference is how the information is reported.

For LLCs taxed as Corporations, things can vary; which is best to discuss this with an accountant.

What are the Other Benefits of Registering an LLC?

Even beyond personal wealth protection and tax efficiency, there are many merits to registering your startup as an LLC. Consider just a few of them.

Credibility

First and foremost, registering your business as a startup confers professional credibility. It demonstrates that your company is serious, not a hobby or a side hustle, which can make it easier for you to court investors or secure a business line of credit.

Regulatory Ease

LLCs also face minimal regulatory burdens when compared to Corporations. There is no need to issue shares, hold annual shareholder meetings, create a board of directors, elect corporate officers, or publish extensive financial reports. And creating and maintaining your LLC is relatively simple, which frees more of your time to run the business.

Managerial Flexibility

LLCs offer tax flexibility, but also flexibility with regard to how you structure your leadership team.

You’ll have the full freedom to run your business all by yourself, to bring in different partners, or even to outsource administrative duties to a third-party management team.

How to Register an LLC

Before taking advantage of these many benefits, you’ll need to complete the formal process of registering your LLC. While the process can look a little different from state to state, the steps involved usually go something like this:

Finalize the Name for Your LLC

What’s in a name? Quite a bit, actually, especially if you’re talking about an LLC. Most notably, LLCs must have names not already in use by other LLCs or entities in the same state. Be advised that, in most states, there is a searchable directory you can use to determine whether the name you want is still available.

Select a Registered Agent

Every LLC is required to have a Registered Agent. This may be an individual or a company tasked with receiving legal correspondence on the business’ behalf. This can include tax documents as well as subpoenas if any arrive. Note that all states will let you serve as your own registered agent, or you can hire a Registered Agent Service. If you're looking for assistance forming an LLC and selecting a Registered Agent, please see the best LLC service for your company.

Draft Your Paperwork

We mentioned the Operating Agreement already. This document can be invaluable for avoiding legal disputes down the road. You’ll also need Articles of Organization, which officially register your LLC with the state. This document can look different depending on where you are, so ensure you get it from your specific Secretary of State (or applicable state agency).

File & Pay

You must complete your Articles of Organization and then file it with your state. This also entails paying the LLC registration cost, usually between $20 and $300. Again, it varies by state, so seek up-to-date information from the governing body.

Get an Employer Identification Number

We’ve talked a lot about taxes already, so just remember that before you can file your taxes, you’ll need to have an EIN for your business. If you’re a resident of the United States (and have an SSN or ITIN), you can get an EIN from the IRS online. You can still get an EIN from the IRS if you are a non-US resident. You just need to apply via mail or fax.

Additionally, if you have a Single-Member LLC, while the IRS allows you to use your Social Security Number for taxes, we recommend getting an EIN as it's needed for banking and other purposes. And it's much safer to give vendors and organizations your EIN Number (as opposed to your SSN).

Establish a Bank Account

One last step: To keep all your finances above board, ensure that you open a business bank account in your LLC's name. This will further help keep business and personal finances separate.

Frequently Asked Questions About LLC Formation

If you’ve never formed an LLC before, it’s only natural to have some questions about it. Here are answers to a few of the most common inquiries about the LLC formation process.

How long does it take to register an LLC?

Approval time can vary by state. On the fast end, it can be 1-2 days. While other states can take a few weeks. You can pay an additional fee in many states to expedite the processing time.

Will I need to pay any annual fees for my LLC?

Most states require you to submit paperwork each year (typically called an Annual Report), simply confirming that your LLC exists and to update any contact information. As always, it’s best to check the specific guidelines provided by your state, as different states have different ongoing requirements for LLCs.

What happens if I change my Registered Agent?

You can change Registered Agent anytime; you simply need to alert the state. Also, let them know if your current Agent changes their contact information in any way, including any change in physical address. If you change your Registered Agent (and were using a paid service before), notify the company so they stop billing you.

Optimize Your Tax Strategy By Registering as an LLC

One of the hallmarks of a profitable business is an efficient tax strategy. To optimize your strategy, ensure you’ve taken the time to register your startup as an LLC.

Registering your company can be an important first step toward claiming pass-through tax status, along with greater flexibility with regard to how you report to the IRS. It’s a simple process that can ultimately boost the financial performance of your entire business.