LLC Pass Through Taxation – What does this Mean for your Business & Taxes?

Jason (P) David
Last Updated: September 13, 2021
Date Published: September 10, 2021

Limited liability companies provide many benefits to its owners including personal liability protection should something go wrong with the LLC.

But personal liability protection is not the only reason why business owners choose this popular business structure.

Limited Liability Companies provide its members with pass through taxation.

If you aren’t familiar with pass through taxation and what it means, you’ve come to the right place!

In this article we are going to learn more about limited liability companies and why pass through taxation is such a huge benefit to business owners.

Let’s get started!

What is a Limited Liability Company?

Limited Liability Companies are simple, flexible and protect the personal assets of its owner or Members.

Furthermore, LLC’s can be owned by more than one person known as LLC “members”.

If the business doesn’t do as well as planned or the LLC ends up in a potential lawsuit, you as the business owner are personally protected from any liability the LLC may incur.

For example, if your Limited Liability Company declares bankruptcy or is sued, your personal assets such as your personal vehicle, personal bank accounts, and house are safe.

But keep in mind that the reason it is called a “limited” liability company is because while the owners or members personal assets are protected, they can still lose the money they invested in the LLC.

Other reasons it is called a “limited” liability company is because there are instances where a court of law could perceive that the LLC owner or members have “pierced the corporate veil.”

To pierce the corporate veil, a court of law would have to determine that the owners or members:

  • Had a personally guarantee on a loan and the LLC defaults on the loan
  • Acted in a negligent or unethical way
  • Conducted their personal affairs in a way that are not easily distinguishable from the LLC. Examples could include joint business and personal bank accounts where expenses are mixed, purchasing personal items with income from the LLC without properly allocating the expenses, etc.

For this reason, we always recommend that Limited Liability Company owners and members keep separate accounting of their personal and business ventures and act in a way that will not put them at risk for piercing the corporate veil.

There are also liability insurance policies specifically designed to add extra protection to LLC members and owners.

pass through taxation

 

Defining Pass Through Taxation

Now that we have a better understanding of what an LLC is, let’s talk about pass through taxation and why so many business owners want it.

Similar to a partnership or sole proprietorship, the IRS considers a limited liability company to be a pass through entity.

Pass through taxation basically means that any profits and losses from the LLC are “passed through” to you and taxed as personal income.

This benefits you because you are not required to pay both corporate and personal taxes on your earnings, you are only taxed once.

Multi-member LLC’s are taxed as partnerships and thus, are also pass-through entities.

This means each LLC member pays personal income taxes on their portion of the profit.

In other words, each member pays taxes on their share of the profits on their personal income tax returns.

Multi-member LLCs must file Form 1065 with the IRS to show that the LLC owners are properly reporting their income.

Owners and members of an LLC are considered self-employed business owners (rather than employees), so taxes are not withheld from their paychecks.

They will be responsible for paying self-employment taxes on their share of the profits which is 15.3% of the LLCs net income.

If there is any income earned above the threshold, an addition 2.9% will be taken.

That may seem like a lot but LLC members can actually deduct business expenses from their personal tax returns, which can further decrease the amounts of profits reported on their income statements to the IRS, thus drastically decreasing their tax bill.

Qualified business expenses include business related travel, inventory, startup costs, promotional expenses, etc.

LLC Taxed as an S Corporation

Sometimes LLC member(s) choose to be taxed as a corporation and thus change their business status from an LLC to an S Corp.

This will require all member(s) to receive a reasonable salary as employees.

If a member of an LLC decides to become an employee and take a salary, the salary will be subject to federal withholding taxes rather than self-employment taxes.

Doing so would decrease the LLCs reported profits and decrease your personal self-employment tax as well.

This can get a little tricky, but when done correctly, there can be some really great tax advantages.

Learn more about S Corporations and their tax advantages here.

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  1. IRS.gov "Limited Liability Company (LLC)" Page 1 . September 9, 2021

  2. IRS.gov "S Corporations" Page 1 . September 9, 2021

  3. Cornell Law School "Piercing the Corporate Veil" Page 1 . September 9, 2021

  4. Cornell Law School "Pass-through taxation" Page 1 . September 9, 2021