Even though the tax system gives LLC owners tremendous benefits, as much as 93% of business owners still overpay on taxes!
A business structure that combines the pass-through taxation benefits of a partnership or sole proprietorship with the limited liability protections of a corporation.
This short guide will show you how to explore the flow of your business income through the tax system, just like a CPA. Knowing how LLCs are taxed will unlock new tax strategies you can consider. Soon, you’ll understand how to use your LLC for big tax savings.
Key Takeaways
- Pass-through entities' profits and losses are passed through to the individual owner's personal tax returns.
- The primary benefit of an LLC is limited liability protection, which shields the personal assets of the owners, however by default, don’t provide a significant impact on your taxes paid.
- LLCs may opt to be taxed as a Sole Proprietorship, Partnership, S Corp, or C corporation.
How an LLC is Taxed
Generally, LLCs are pass-through entities, where profits pass through to owners' individual taxes. Most small business owners are taxed between 14% and 39% on their self-employment income. However, your tax rate will differ depending on your situation and your LLC’s tax structure.
Limited Liability Companies (LLCs), because of their ease and flexibility in both operation and taxation, are widely used. They can be taxed according to 4 different tax structures: Sole Proprietorships, Partnerships, S Corps, and Corporations; below we summarize the tax treatment of each structure.
By default, LLCs are treated as pass-through entities for tax purposes. This means that the LLC itself does not pay taxes directly to the government. Instead, the profits and losses of the LLC "pass-through" to the individual owners, who report them on their personal tax returns.
Sole Proprietorship
This is the default classification for single-member LLCs. The IRS considers it a disregarded entity that passes all income to the owner. This income is subject to both federal self-employment as well as income taxes.
Partnership
The default classification for multi-member LLCs. Partnerships also pass-through income to owners according to their LLC agreements. In most cases, the partners' incomes are subject to federal self-employment and income taxes.
S Corp
S Corporation is a tax classification that LLCs may select instead of their default structure. While still a pass-through entity, S Corps have special rules applied by the IRS. This income is subject to federal employment, income, franchise, and payroll taxes.
Corporation
A C Corporation or a C Corp is a tax classification that LLCs may opt into to replace their default status. This creates a separate legal entity where income does not simply pass through to owners. Income from this tax structure can become subject to federal employment, income, franchise, payroll, corporate income, and other taxes.
Federal Taxes for LLCs
Federal taxes make up the largest portion of most LLC owners' annual tax expenses. The average federal effective tax rate for a regular LLC owner making $70,000/yr is around 20%. There are four major federal taxes for LLC owners to be aware of.
Social Security
Social Security is the single most important tax LLC owners need to understand. That’s because it’s the largest single tax bill for most self-employed individuals. Included in Self-Employment taxes, Social Security is a 12.4% tax on nearly all of your business income.
Good News For High Earners
All income above the Social Security cap ($160,200 for 2023) is no longer subject to this tax. However, this income will still be taxed by Medicare and income taxes.
Medicare
The second part of the Self-Employment Tax, Medicare, is a much smaller 2.9% tax on nearly all your business income. It can be a large tax for high-income earners because, unlike Social Security, there’s no cap. Worse news still, the rategets as high as 3.8% for super-high income earners.
Federal Unemployment
Also known as Federal Unemployment Insurance, this tax only applies to LLC owners that have changed their tax structure. Part of the group known as “Payroll Taxes”, it’s only applicable to W2, salaried employees.
Federal Income Taxes
A well-known tax that’s usually smaller than Social Security for most LLC owners. Its tax brackets range from 10 - 37%, which is frequently confused with the idea of an effective tax rate (a notion that takes into account all taxes paid). After applying deductions this tax is applied to all taxable income.
The percentage of your total annual income you must pay for all your tax obligations. It takes into account complexity, such as progressive tax brackets, credits, and deductions.
Other Federal Taxes
Depending on the tax structure of an LLC, it may be subject to other federal taxes, such as the Capital Gains Tax, Alternative Minimum Tax (AMT), and the Net Investment Income Tax (NIIT) on certain investment income. The majority of LLCs do not pay any of these taxes.
State Taxes
State taxes are usually much smaller than those paid on the federal level. Tax rates at the state level can vary dramatically, for example, top income tax brackets range from 0% - 13.3%. Each state selectively applies the following taxes.
State Income Tax
States with the most onerous income taxes are usually the most expensive for small business taxes. As of 2024, 9 states have no income tax, which we ranked among the best for LLC taxes.
Zero Income Tax States
Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. However Washington does impose a special tax on all business gross receipts.
State Unemployment
Part of the group known as “Payroll Taxes” - State Unemployment Insurance isn’t an immediate concern for most LLC owners. These taxes only apply to W2, salaried employees, which S Corps and Corporations may grant to their owners.
Franchise Taxes
Some states impose franchise taxes on businesses, but it’s not a common concern for most LLCs. In most cases, these taxes only apply to S Corps and Corporations. However, in some states, these taxes can be particularly onerous.
It’s better to be safe than sorry, so speak with tax professionals about franchise taxes before changing your tax structure or moving your LLC to a new state.
Best to Worst States for LLC Taxes
It’s impossible to create a list relevant to all taxpayers, however, our list attempts to reflect the average LLC owner. We used this same LLC calculator above for the tax year 2023. Our subject was a sole proprietor / LLC earning $70,000/yr as a single filer.
| State | Tax | Rate |
|---|---|---|
| Alaska | $0.00 | 0.00% |
| Florida | $0.00 | 0.00% |
| Nevada | $0.00 | 0.00% |
| New Hampshire | $0.00 | 0.00% |
| South Dakota | $0.00 | 0.00% |
| Tennessee | $0.00 | 0.00% |
| Texas | $0.00 | 0.00% |
| Wyoming | $0.00 | 0.00% |
| North Dakota | $122 | 0.17% |
| Washington | $1,050 | 1.50% |
| Ohio | $1,147 | 1.64% |
| Arizona | $1,275 | 1.82% |
| Louisiana | $1,983 | 2.83% |
| Pennsylvania | $1,991 | 2.84% |
| Indiana | $2,011 | 2.87% |
| New Jersey | $2,035 | 2.91% |
| New Mexico | $2,219 | 3.17% |
| Colorado | $2,244 | 3.21% |
| Rhode Island | $2,267 | 3.24% |
| Vermont | $2,280 | 3.26% |
| California | $2,288 | 3.27% |
| Missouri | $2,341 | 3.34% |
| Mississippi | $2,351 | 3.36% |
| Wisconsin | $2,391 | 3.42% |
| Connecticut | $2,411 | 3.44% |
| Michigan | $2,408 | 3.44% |
| North Carolina | $2,475 | 3.54% |
| Oklahoma | $2,543 | 3.63% |
| South Carolina | $2,622 | 3.75% |
| Maryland | $2,762 | 3.95% |
| Nebraska | $2,817 | 4.02% |
| Kansas | $2,861 | 4.09% |
| Maine | $2,892 | 4.13% |
| Arkansas | $2,934 | 4.19% |
| Kentucky | $2,952 | 4.22% |
| Idaho | $2,958 | 4.23% |
| Virginia | $2,958 | 4.23% |
| West Virginia | $2,960 | 4.23% |
| Utah | $2,977 | 4.25% |
| New York | $2,985 | 4.26% |
| Massachusetts | $3,022 | 4.32% |
| Minnesota | $3,033 | 4.33% |
| Alabama | $3,044 | 4.35% |
| Georgia | $3,090 | 4.41% |
| Montana | $3,147 | 4.50% |
| Delaware | $3,323 | 4.75% |
| Iowa | $3,405 | 4.86% |
| Illinois | $4,082 | 5.83% |
| Hawaii | $4,327 | 6.18% |
| Oregon | $5,841 | 8.34% |
Taxes should never be your sole consideration when choosing a state for your business. Speak to qualified professionals before making important changes to your business structure.
How Much to Set Aside for LLC Taxes?
A common practice is to set aside 30 - 35% of your self-employment income for taxes. Self-employed individuals are expected to make quarterly payments to the IRS or risk paying penalties. Your state may expect quarterly payments as well.
Speak with a tax professional to ensure you are setting aside enough and making payments to the correct tax authorities.
Common Small Business Tax Deductions
Your business income in this LLC tax calculator assumes you’ve already deducted all relevant expenses. Check that you’ve deducted all the following important business expenses from your revenues.
- Advertising and promotion
- Business meals
- Insurance
- Interest and bank fees
- Business use of car
- Contractor Labour
- Depreciation
- Education
- Home office
- Legal fees
- Moving
- Rent
- Salaries
- Telephone and internet
- Travel costs
How Do LLCs Save on Taxes?
As we've discussed above, by default, LLCs do not give any preferential tax treatment to their owner(s). One advantage LLCs have is the ability to change their tax structure into an S Corp. This special tax structure allows owners to exempt some of their income from self-employment, resulting in significant tax savings.
To see if your business might save on taxes by switching to an S Corp, try our free S Corp Tax Calculator. S Corps can be an excellent strategy for the right business, but they have major drawbacks. It’s essential to talk with a qualified business tax professional before switching to an S Corp.
