An LLC, by default, is taxed as a “pass through” entity, where income is reported on the member’s personal return on Schedule C. An LLC may also make an election to be taxed as C corp, where your entity will be taxed as a corporation and thus subject to the 21% federal corporate tax rate, or an S corp, which is taxed much like a pass through entity, with some benefits using salary and distributions to members to avoid Social Security and Medicare taxes.
A single member entity, by default, is a “disregarded entity” according to the IRS. Essentially, they are treating you as having earned the money and are not necessarily worried about the entity itself—the tax burden will fall to you entirely. This will not affect the legal status of your LLC. If you are still following the corporate formalities and making sure to be in compliance with your own operating agreement, you will still enjoy the liability protection of an LLC if the IRS treats it as a disregarded entity. Click Here To Read More About Pass Through Taxation For LLCs in Texas.
Electing to be taxed as a C corp means that the entity will be taxed like a corporation, and be responsible for filing a corporate tax return, Form 1120, US Corporation Tax Return. The corporation will pay taxes on any earnings and you as the member will pay taxes on any salary given by the corporation. State and local taxes for corporations will also play a role in deciding to make this election as an entity.
An S corp election is more common than a C corp election for smaller LLC’s. As an S corp, the goal is to avoid certain taxes paid on salaries vs earned distributions. A modest but reasonable salary paid to the members of the LLC will be taxed like a normal salary with taxes such as Social Security and Medicare taken out. Distributions, however, will not. There are also considerations as to the Self-Employment tax when it comes to S corps that are worth discussing with your CPA when forming your corporation. Click here to read more about DIY LLC Formation.
Texas Franchise Tax Obligations:
In Texas, LLCs are subject to the state’s franchise tax, which is essentially a tax on the privilege of doing business in the state. This tax applies to most businesses, including LLCs, whether they are single-member or multi-member entities. The franchise tax is calculated based on the company’s revenue, with rates varying depending on the entity’s total annual revenue. For example, if your LLC earns less than $1.23 million in annual revenue, it might qualify for a no-tax-due threshold, meaning you won’t owe any franchise tax but are still required to file a report. For LLCs with revenue above this threshold, the tax rate is typically 0.375% for entities primarily engaged in retail or wholesale trade and 0.75% for other businesses.
Business License Requirements:
Texas does not require a general business license for LLCs, but depending on the nature of your business, you may need specific permits or licenses at the state or local level. For example, if your LLC is involved in selling alcohol, operating a daycare, or offering professional services like accounting or legal advice, you will need to obtain the appropriate licenses. It’s important to check with your local city or county office to determine if there are any additional requirements, as these can vary widely depending on the location and type of business.
Potential Fees and Annual Obligations:
In addition to the franchise tax, Texas LLCs have annual reporting requirements. LLCs are required to file an annual Public Information Report (PIR) along with their franchise tax report. This report lists the names and addresses of the LLC’s officers and directors and is due every year by May 15th. Failure to file this report on time can result in penalties, including the loss of good standing with the state. Additionally, while Texas does not impose an annual fee for maintaining an LLC, it’s important to budget for any applicable state filing fees, franchise taxes, and the costs associated with renewing specific business licenses.
S Corp vs. C Corp Election
Corporation Election:
A Corporation election can be a strategic choice for LLCs looking to reduce the overall tax burden on their business. By electing Corporation status, the LLC can pay its owners (members) a reasonable salary, subject to payroll taxes (Social Security and Medicare), and then distribute the remaining profits as dividends, which are not subject to these payroll taxes. This can lead to significant tax savings. For instance, if an LLC generates $200,000 in profits, the owners might decide to take a $100,000 salary (subject to payroll taxes) and $100,000 in dividends, reducing their overall tax liability.
However, the IRS scrutinizes the “reasonable salary” aspect closely, and paying an unreasonably low salary to maximize dividend distributions can trigger audits and penalties.
Electing to be taxed as a C Corporation might be advantageous for LLCs that plan to reinvest profits back into the business rather than distributing them to members. C Corps benefit from a flat 21% federal corporate tax rate, which can be lower than the combined personal income tax rates that apply to pass-through income from an S Corp. Additionally, C Corps have no restrictions on the number or type of shareholders, making them a better fit for businesses seeking significant outside investment or planning to go public.
However, the downside of a C Corp election is the possibility of “double taxation.” This occurs when the corporation’s income is taxed at the corporate level and then again at the individual level when profits are distributed to shareholders as dividends. For example, if your LLC earns $100,000, the corporation pays 21% in federal taxes, and any distributed dividends are taxed again on the members’ personal returns.
Pass-Through Taxation
Single-Member LLCs:
For single-member LLCs, pass-through taxation means that all business income, deductions, and credits are reported on the owner’s personal tax return, specifically on Schedule C of Form 1040. This can simplify tax reporting, as the LLC itself is not required to file a separate tax return. However, one potential pitfall is the self-employment tax, which applies to all net earnings from the business. As of 2024, the self-employment tax rate is 15.3%, covering both Social Security and Medicare taxes. This can result in a higher tax burden compared to a corporation where income is split between salary and dividends.
Multi-Member LLCs:
In multi-member LLCs, pass-through taxation involves reporting the business’s income and losses on each member’s personal tax return in proportion to their ownership interest. The LLC itself must file a partnership tax return (Form 1065), and each member receives a Schedule K-1, which details their share of the income and deductions. While this structure avoids the double taxation faced by C Corps, it also means that all profits are taxed whether or not they are distributed to members, potentially leading to higher personal tax liabilities, especially if the LLC retains earnings for reinvestment.
Pitfalls to Avoid:
One of the common pitfalls for LLCs under pass-through taxation is the mismanagement of distributions. For example, failing to set aside enough cash to cover the tax liabilities that pass through to members can lead to financial strain when taxes are due. It’s also crucial to maintain accurate records and ensure that all members are aware of their tax obligations, as the IRS can impose penalties for underpayment or late payment of taxes. Additionally, LLC members should work closely with a CPA to navigate any complexities, such as the treatment of self-employment tax and the potential impact of pass-through income on personal tax brackets.
Frequently Asked Questions
The Texas franchise tax is a tax on the privilege of doing business in Texas, applicable to most LLCs. Whether your LLC needs to pay this tax depends on your total annual revenue. If your LLC earns less than $1.23 million annually, you may qualify for the no-tax-due threshold, meaning you won’t owe any franchise tax but still need to file a report. LLCs with revenue above this threshold are subject to a tax rate of 0.375% for retail or wholesale businesses and 0.75% for other businesses.
Texas does not require a general business license for LLCs. However, depending on the nature of your business, you might need specific licenses or permits. For instance, businesses involved in selling alcohol, operating a daycare, or providing professional services may require state or local licenses. It’s important to check with local authorities to ensure compliance.
Electing Corporation status can be advantageous if you want to reduce payroll taxes by taking a reasonable salary and receiving the rest of the profits as dividends, which aren’t subject to Social Security and Medicare taxes. However, Corporations must adhere to strict IRS guidelines, including paying a reasonable salary to owners. Missteps can result in penalties, so it’s important to consult with a tax professional before making this election.
For single-member LLCs, pass-through taxation means all business income is reported on the owner’s personal tax return, simplifying the process but potentially leading to a higher self-employment tax burden. Multi-member LLCs must file a partnership tax return, and each member reports their share of the income on their personal tax returns. While this avoids double taxation, all profits are taxed whether or not they are distributed, which can impact personal tax liabilities.
Besides the Texas franchise tax, LLCs must file an annual Public Information Report (PIR) with their franchise tax report. This report is due by May 15th each year and lists the LLC’s officers and directors. While Texas does not charge an annual fee for maintaining an LLC, failing to file required reports can result in penalties and loss of good standing with the state. It’s crucial to stay on top of these obligations to avoid issues.
San Antonio Small Business Attorney Nathaniel Gilbert helps clients look for the right entity strategy to fit their goals and needs, using an efficient and structured approach. To learn more about Texas Business Law, Click Here. To get in touch with Nate directly, Click Here.
