The Overlooked Tax Secrets of LLC

Limited liability companies (LLCs) exploded in popularity over the past decade, shielding millions of business owners from personal liability. Nearly everyone knows LLCs limit liability, but few realize the immense tax advantages buried in arcane IRS regulations. Unlocking these hidden tax loopholes takes decoding complex legal jargon spanning hundreds of pages.

Yet within those densely-worded paragraphs lie methods to wipe out double or even triple taxation of business profits. The tax savings can easily surpass the liability protection itself. Those leveraging these tax secrets can funnel tens of thousands back into their pockets each year.

So what exactly are these overlooked tax advantages? This article will uncover the key strategies savvy LLC owners use to minimize their tax bill. You’ll learn the crucial differences between LLCs, S corps and C corps when it comes to taxes. You’ll discover how concepts like distributions and carried interest can be used to legally circumvent high tax rates when setting up an LLC in OK. Not only that, but you’ll even see specific examples of how Oklahoma business owners structure their LLCs to maximize write-offs.

By the end, you’ll view your LLC in a whole new light: as a valuable tool to retain more of your hard-earned profits.

One of the most valuable but overlooked benefits of LLCs is flexibility in tax classification. LLCs can elect how they wish to be taxed by filing IRS form 8832. Unlike sole proprietors or partnerships which have no choice, LLCs can choose between being taxed as a sole proprietorship, partnership, S corporation or C corporation. This ability opens the door to substantial tax savings not accessible otherwise.

Electing to have an LLC taxed as a sole proprietorship enables business income and expenses to be reported directly on the owner's personal tax return using Schedule C. This avoids having to file a separate business tax return. As a sole proprietorship, net business profits are subject to the self-employment tax. While sole proprietorship taxation is the simplest option, better alternatives exist to reduce tax liability.

Electing S corporation status for an LLC enables business owners to avoid self-employment taxes, which can result in thousands in savings annually. S corporations are considered a pass-through entity - income and losses "pass through" the business to be reported on the personal tax returns of owners. The key benefit comes from only having to pay self-employment tax on wages paid to owner-employees, unlike sole proprietors who pay this tax on all business income.

Additionally, S corporation owners can often qualify for the 20% qualified business income deduction starting in 2018, deducting up to 20% of business income on their personal tax return. There are some limitations based on owner compensation and total income that may reduce the available deduction. Overall, however, the ability to avoid self-employment taxes and potentially deduct 20% of income makes an S corporation election very appealing.

Choosing C corporation status means the LLC will be taxed at the corporate level on net business income. In some cases, this double taxation can be minimized to reduce the overall tax burden. One method is by paying a reasonable salary to owner-employees. This allows taking tax deductions for salaries and benefits at the corporate level while only the net profit remainder is taxed. Owners still must pay income tax on salaries received, but this splits income into two lower tax brackets rather than one high bracket.

One major advantage of LLCs over sole proprietorships is the ability to take tax deductions at the entity level before profits pass through to personal tax returns. Maximizing these business-level deductions reduces taxable income for LLC owners.

With more businesses operating from home offices, one of the most valuable deductions is for using space in your home for business purposes. To qualify, you must use the space regularly and exclusively for business. If you meet the requirements, you can deduct a portion of household expenses like rent, utilities, insurance, security system costs, and certain improvements.

Beyond the basic household expenses mentioned already, LLCs can potentially deduct a wide variety of other costs associated with a home office:

Tracking these expenses and determining the appropriate home office deduction percentage can get complex, so consult a tax professional. But the savings can be substantial if you qualify.

To claim the home office deduction, the IRS has specific criteria around exclusive and regular business use of the space. Additionally, the office space must be your principal place of business or used to meet clients in the normal course of business. We recommend reviewing IRS Publication 587 for details to ensure you qualify.

In addition to deductions that reduce taxable income, LLCs also have access to a variety of business tax credits at the federal and state level. These credits provide dollar-for-dollar reductions in the taxes owed, making them particularly valuable.

One of the most lucrative but overlooked credits is the Research Tax Credit. Despite the name, most small businesses can qualify. Activities like developing new products or services, improving manufacturing processes, or even overhauling software systems can potentially qualify for this credit. There are accounting methods that make calculating the available credit straightforward. Given the substantial savings possible, the Research Tax Credit should be on every LLC owner’s radar.

Another valuable credit comes from hiring employees from certain targeted demographics. The Work Opportunity Tax Credit provides thousands in potential federal credits for hiring veterans, food stamp recipients, those with disabilities, ex-felons, and those unemployed for extended periods. The credit is calculated as a percentage of qualified employee wages for the first two years of employment. Most states have additional hiring credits, making this even more lucrative.

LLCs taxed as partnerships can utilize an interesting strategy known as "guaranteed payments" to provide favorable tax treatment for LLC members who manage the business. These payments function as compensation for services rendered in operating the LLC.

Guaranteed payments to LLC members are treated as ordinary income for tax purposes, avoiding the self-employment tax that would normally apply to member partnership distributions. This benefit alone results in Medicare and Social Security tax savings of over 15% that members would otherwise owe on their profit share.

Since guaranteed payments are taxed as compensation and not distributions, no self-employment taxes apply. Members receiving guaranteed payments only pay Medicare and Social Security taxes on the amounts paid as ordinary wages. This can lead to thousands in tax savings each year that would have otherwise been lost to self-employment tax.

The key is determining reasonable compensation levels for members that accurately reflect their involvement while not triggering IRS scrutiny. Work with a qualified tax professional to implement this advanced strategy.

LLCs structured as investment partnerships can take advantage of a tax loophole known as "carried interest." This creative profit-sharing arrangement enables the managing partners to receive a share of future profits without investing upfront capital.

Carried interest payments are structured as long-term capital gains, allowing managing partners to benefit from the substantially lower capital gains tax rates. Rather than pay 37% at the highest ordinary income bracket, carried interest income can be taxed at just 20% instead. This preferential treatment has sparked controversy but can yield major tax savings.

Fund managers utilize carried interest arrangements in private equity, venture capital, and hedge funds as a form of incentive executive compensation. By allowing managers to share in investment profits without initial risk, carried interest motivates managers to maximize returns. LLCs can implement similar structures to incentivize executives while minimizing tax burdens.

Business profits not reinvested into growing an LLC are typically distributed to the members. How these distributions are structured and later taxed can significantly impact total tax liability.

When members make capital contributions to initially form an LLC, these contributions make up the company's basis. Distributions up to this basis amount are considered tax-free return of capital rather than taxable income. Tracking basis and initially distributing up to this amount allows deferring profit distributions.

An additional advantage of LLCs lies in how asset sales are taxed. LLCs can pass gains or losses from selling real estate, equipment, or other assets directly through to the personal tax returns of members. This differs from C corps, which face double taxation on asset sale gains. For LLCs with major fixed assets, this can represent major tax savings.

Optimizing an LLC for maximum tax savings takes strategic planning and navigating complex regulations. While the administrative burden can seem daunting, the payoff makes the effort well worth it. Carefully weighing options around entity classification, accounting methods, business credits, carried interest arrangements, and distributions can lead to substantial tax reductions.

For those setting up an LLC in OK, be sure to understand how your choices at formation affect taxation down the road. Work closely with both a business lawyer and tax professional to implement the strategies outlined here. View compliance requirements not as a hassle, but as a tax-minimizing opportunity. With the right LLC structure, you can potentially save tens of thousands each year that would have otherwise been squandered. Who doesn’t want to keep more of their hard-earned profits?