You've likely heard that LLCs can reduce your taxes and I'm here to tell you that's absolutely true!
As an LLC owner you’re able to reduce taxes by:
- Changing your tax classification.
- Claiming business tax deductions.
- Using self directed retirement accounts.
- Deducting health insurance premiums.
- Reducing taxable income with your LLC's losses.
Each of these strategies can serve a crucial role in reducing your taxes by applying them to your unique situation. Let's discuss how each one works and how you can start taking advantage of it.
#1 Changing Your Tax Classification
The ability to change your tax classification is the most important driver of tax savings for many LLCs.
When you become an LLC you’re able to change your default tax classification (disregarded) to something that better suits your needs. Sole Proprietors do not have this ability to change their tax classification, only corporations (like LLCs) do. Changing your tax classification to either an S Corp or a C Corp can cause broad changes to your overall strategy, so be sure to discuss these options with your CPA first!
While still a pass-through entity just like a regular LLC, this is a popular option for helping business owners avoid expensive self employment taxes. Important to note that S Corps may not work for all LLCs, especially if you need more flexible ownership rules. However if your curiosity is peaked, please checkout this S Corp calculator to see if changing to this tax classification would create big savings for you.
The C Corp is not as popular with self employed because it exposes you to corporate level taxes, however it can play a role in more sophisticated tax strategies. Again changing to a C Corp can easily expose you to more taxes than you are paying now. That said it’s a valuable option to have on the table for both disregarded and S Corp LLCs.
Becoming a C Corp is one of the most dramatic changes you can make to your LLC. Because of the affects on your tax situation, getting guidance from your tax professional is a must to using this option properly!
#2 Claiming Powerful Deductions
LLCs have some amazing deductions allowed to them by the IRS, which you absolutely must take advantage of! The simplest of these is the self employment deduction or the employer-equivalent portion of your Social Security and Medicare taxes. A popular deduction in recent years is the QBI or “Qualified Business Income”.
The QBI or "qualified business income" deduction allows owners of eligible pass through entities, like LLCs, to deduct up to 20% of their eligible business income on their taxes.
QBI is a below the line deduction which means it is mostly useful in reducing your income taxes. While it’s unhelpful reducing Social Security and Medicare taxes, the savings are still substantial for some llc owners reducing their adjusted gross income up to 20%. Not all LLC will qualify as you must meet the IRS definition of a “specified service trade or business” to get the full deduction. For that reason it’s important to discuss this with your CPA.
There’s of course more deductions you can explore that are helpful to LLC owners. Options to look into are the home office and leasing use of your personal vehicle to your business. These and other deductions are options that LLC owners have to reduce taxes.
#3 Self-Directed Retirement Accounts
Self employed have the ability to invest through a number of tax saving vehicles including: SEP-IRA, Simple IRA, Solo 401(k). Yes I know that's a lot of acronyms! So if you're new to retirement accounts just know that while they each have pros and cons over one another, they have the same goal: to help you reduce and defer your taxes.
Here’s some key tax advantages LLC owners have with their retirement accounts:
- Fully deductible contributions.
- More investment options than employees (ie rental properties).
- More control over how you invest than employees.
Money you invest through your LLC’s retirement account counts as your compensation and is contributed pre tax. While employee’s have a similar option through their 401 (k) plans, the self-employed have more flexible vehicles available to them like the SEP-IRA.
What this boils down to is you are in the driver's seat of your retirement plan to a greater degree than employees are. Because this comes with added complexity it's important to review these options in detail with your CPA.
#4 Deducting Health Insurance
This was broken out into its own section because it’s so frequently overlooked! Self employed people are able to deduct Health insurance premiums above the line (most valuable kind of deduction). This includes both medical and dental health insurance premiums for you and your dependents.
As you may have guessed by now there’s of course some restrictions to be aware of in order to claim this deduction.
You must report a profit from your business.
You must not be eligible for a plan through your spouse's employer.
You must manage and document premium reimbursement through your business.
S Corps Owners Must Be Salaried
If your LLC is taxed as an S Corp (that you're a > 2% owner of) you must receive a salary from your business. This is to say you can't just be an investor in the LLC. On the pulse side this does count towards your W2 compensation, so factor that in when planning your distributions.
Read all the details of deducting health insurance premiums in IRS Publication 535 page 20. Below you'll find a worksheet for determining your exact health insurance deduction. This publication is very helpful guidance on many other types of business deductions as well!
#5 Offset Income with Losses
An often overlooked advantage of a LLC is that net operating losses from your LLC can be used to reduce your income from other sources. For example if your LLC lost $50,000 in 2020 and yet you earned $100,000 in other income your taxable income would only be $50,000. There’s some limitations and other options as well.
You can carry forward excess losses to future years
There’s a maximum amount of losses you can apply in a given year
You can only shelter up to 80% of your taxable income
While losing money is nothing to get excited about, it’s extremely beneficial to know how you can leverage this loss as a business owner. This is particularly true for serial entrepreneurs with at least one profitable business expecting losses in a new venture.
Bonus: More Control Over Your Tax Strategy
If you’ve made it this far you’ve likely noticed a recurring theme: you have the control. In many cases employees have to accept the options offered to them by their employer. For example if an employer does not want to offer their employees a HSA (Health Savings Account) then it’s simply not going to happen!
As a self employed LLC owner you can set up your own HSA, if that’s what you want to do. Similarly if you want to invest in passive rental properties with your IRA, that’s possible too. If you’re wanting to contribute more to your retirement for example you can choose to do that by opting for a SEP-IRA or Solo 401 (k).
All of this just means that you have control over your tax strategy, not your employer. Employees are often stuck contributing to investments that unfortunately play more into the hand of Wall Street. As an LLC owner you are more empowered to steer the ship of your investment strategy towards your goals.
You’ve just learned about some of the most interesting tax saving ideas for your LLC. It’s easy to get overwhelmed by all this information, so try and approach these strategies one by one. Checkout our S Corp tax savings calculator and see if your business has potential there. Then speak with your accountant or tax professional about each of these ideas.
Once you decide on pursuing one of these strategies it’s important to set a system to put it on autopilot. Whether that’s a checklist for filing your 1040 or setting up your bookkeeping software to track key transactions! The surest way of claiming all the tax advantages of your LLC is to make it easier on yourself starting today.