If you are thinking about forming a single-member or multi-member limited liability company (LLC), you’ll need to choose between corporate or pass-through taxation when structuring your business. Both options feature distinct advantages and potential drawbacks, each defined in scope depending on the nature and goals of your business.
This isn’t a decision that you should approach lightly. Understanding the differences between these two taxation structures can help you make an informed decision that aligns with your vision for your company.
Pass-through taxation
Unless members elect otherwise, LLCs are taxed as pass-through entities by default. This means that an LLC itself does not pay federal income taxes. Instead, LLC member(s) account for their share of their company’s income or losses on their individual tax returns.
For many small businesses, pass-through taxation is a simpler and more cost-effective option. Members can benefit from lower overall tax rates, and business losses can offset other income, which may reduce the owner’s overall tax liability. However, there are limitations. LLC members who choose pass-through taxation must pay self-employment taxes on their share of the profits, which can add up, especially as the business grows.
Corporate taxation
Alternatively, an LLC can elect to be taxed as a corporation. The most common corporate tax structure chosen by LLCs is the C-corporation. Under corporate taxation, the LLC is treated as a separate tax entity, paying corporate income tax on its profits at the federal level. Members are only taxed on dividends they receive, which results in double taxation—once at the corporate level and again at the personal level.
Despite the double taxation, corporate taxation can offer advantages for certain LLCs. One major benefit is that only the company’s profits—not the owners’ entire share—are subject to corporate tax rates, which can be advantageous for businesses looking to reinvest profits back into the company. Additionally, choosing corporate taxation also allows for more flexibility with fringe benefits like health insurance or retirement plans, which can be deducted from corporate income.
At the end of the day, pass-through taxation is typically best for smaller businesses seeking simplicity and tax efficiency, while corporate taxation may be advantageous for larger LLCs aiming to reinvest profits or offer substantial employee benefits down the line. Either way, you’ll want to consider your options carefully before making a decision.