Limited liability companies (LLCs) get talked about like they’re the ultimate tax cheat code. Just register one and watch your taxes shrink. Unfortunately, adding three letters to your business name doesn’t automatically subtract from your tax bill. It’s all in how your business is taxed.
Forming the LLC is just the beginning
You filed the paperwork and officially became Initech, LLC. So, now you’re ready to save on your taxes, right? Maybe. But simply forming the LLC isn’t what affects your tax bill.
An LLC is a type of business entity set up under state law. It describes your business structure, but it doesn’t tell the IRS how that business should be taxed. A single-member LLC is treated like a sole proprietorship by default unless it elects otherwise. So, if you were reporting your business income on your personal return before the LLC, there’s a good chance you’ll continue to do that.
If there’s more than one owner, you have a multi-member LLC, which is taxed as a partnership by default. For federal income tax purposes, that may mean that very little changes unless you select corporate tax treatment.
No bonus write-offs included
A shiny new LLC also doesn’t come with a fresh batch of deductions or make you suddenly qualify when you didn’t before. If your laptop, home office, mileage, or other expenses weren’t deductible last year, adding LLC to your business name isn’t going to change the rules this year.
So why do so many business owners swear that forming an LLC saved them money on taxes? Well, there’s one pretty important detail they’re leaving out.
See what may actually be behind those tax savings.
Get more articles like this straight to your inbox 
Free as a meme, easy to bail anytime.
Here’s where the savings kick in
Remember how we said an LLC can choose a different tax treatment? Now we’re getting somewhere.
An eligible LLC can elect to be taxed as an S corp. That’s a completely separate decision from forming an LLC, and it is that decision that can potentially change the math on your tax return.
With an S corp, an owner who works for the business is generally required to receive reasonable compensation. Additional profits may be taken as distributions, which usually aren’t subject to employment taxes the same way wages are. That can mean tax savings for some business owners.
But before you race off to elect S corp status, understand what that entails. S corps have rules, payroll responsibilities, additional paperwork, and extra costs. And reasonable compensation means exactly what it sounds like. You can’t pay yourself pocket change, and call everything else a distribution. Save the creativity for your branding – not the IRS.
So, if someone says they formed an LLC and saved thousands of dollars on taxes, the LLC may be taking credit for something it didn’t actually do. The tax election may actually be the unsung hero.
Then why should I form an LLC?
There are benefits to forming an LLC. Getting an automatic tax discount just isn’t one of them.
One of the biggest potential benefits is liability protection. LLC members generally aren’t personally liable for the company’s debts and obligations. You’ll also get flexibility in terms of ownership, management, and tax classification.
The specifics vary by state, and forming an LLC isn’t the right move for every business. But there are plenty of good reasons to form one. Just don’t expect an extreme tax makeover when it’s time to fill out your return.
Forming an LLC and choosing how it’s taxed are two very different decisions. If saving on your taxes is your goal, talk to a tax professional about your options before assuming three letters are going to do the heavy lifting.
