How Does an LLC Avoid Double Taxation: Everything You Need to Know

Taxes are tedious and confusing if you don’t know what you’re doing. Legal entities like startups and other businesses are all required to pay taxes. This can get more complicated, as the IRS may or may not require you to pay your taxes twice, depending on your business structure of choice.

The double taxation policy requires businesses to pay their taxes twice on the same income. This specific policy often applies to startups structured as corporations, international trades or investments, and traditional IRAs.

Luckily, LLCs who want to avoid double taxation can adopt various strategies to work around it. But before you look into how to prevent multiple taxes, you need to determine if the rule applies to your startup.

This article discusses how double taxation works, explores whether LLCs are double taxed, and how businesses can avoid them.

How Double Taxation Works

Corporations, like any other business entity, must pay their taxes at the end of every fiscal year. Since owners are legally considered separate from their shareholders, they are taxed depending on their annual income. 

But, if their earnings are distributed, the company’s shareholders must pay their taxes depending on their shares. An example of this would be the following:

Suppose a store earns $850,000 during the 2021 fiscal year and distributes $350,000 to its shareholders. They would have to pay $178,500 in taxes. Their shareholders will also be required to pay another set of taxes depending on their respective shares.

Additionally, there are two categories of double taxation: corporate and international double taxation agreements.

Corporate double taxation involves taxing business earnings twice on two different levels: corporate and dividend tax. This policy is common in the US and other countries. 

Meanwhile, international double taxation mainly applies to multinational entities that operate outside the jurisdictions of their home country. In certain instances, it can also affect the foreign income of individuals in other countries.

Pass-Through Taxation for LLCs

In an LLC, the business itself does not pay taxes on its income. Instead, the profits and losses are reported on the individual tax returns of the LLC’s owners, known as members. This means that the LLC is not subject to federal income tax at the entity level.

Pass-through taxation offers several benefits to LLC owners. These include the following:

• Single Taxation: With pass-through taxation, the LLC avoids the corporate income tax. Profits are taxed only once, at the individual level, based on each member’s share of the company’s income. This can result in overall tax savings compared to corporations.
• Flexibility: LLCs have flexibility in how they allocate profits and losses among members. This allows for strategic tax planning, as members can distribute income in a manner that minimizes their overall tax liability.
• Simplicity: Pass-through taxation simplifies tax compliance for LLCs. There’s no need to file a separate tax return for the business itself, as all income and deductions flow through to the members’ personal tax returns.
• Loss Deductions: LLC members can deduct their share of the company’s losses against other income on their tax returns, subject to certain limitations. This can offset personal tax liabilities and provide a measure of financial relief during challenging years.

Bear in mind that LLC members are still responsible for paying self-employment taxes on their share of the LLC’s income. The tax treatment of LLCs can also depend on factors like the number of members, the type of business activities, and the state in which the LLC is registered.

Do LLCs Have Double Taxation?

Fortunately, LLCs are not double-taxed. Startups structured as C corporations are the only entities paying their taxes twice. S corporations and sole proprietors can also avoid double taxation. 

Unlike C corporations, LLCs and sole proprietors are legally considered pass-through entities. The structure means their earnings go directly to their owners, who pay their taxes through their personal income tax. 

Another way you can avoid double taxation is by adopting the S corporation structure. Like LLCs, S corps are not required to pay their taxes twice. Instead, the IRS taxes them in the same way they tax partnerships.

Ultimately, if you want to structure your venture as an LLC, you don’t have to avoid double taxation anymore, as you won’t be taxed twice by default.

How Do LLC Taxes Work?

The K-1 tax form is integral to how LLCs handle taxes. 

Unlike traditional corporations, LLCs are pass-through entities for tax purposes. This means that the profits and losses of the business “pass-through” the LLC and are reported on the individual tax returns of the owners rather than being taxed at the entity level.

Each year, LLCs issue a Schedule K-1 to each member (owner), outlining their share of the LLC’s profits, losses, deductions, and credits. This information is then reported on the member’s personal tax return. The K-1 ensures that each member is responsible for paying taxes on their portion of the LLC’s income at their individual tax rate.

It’s important to note that even if the LLC does not distribute profits to its members, they may still owe taxes on their share of the profits. This is because the IRS considers the allocated profits as income, regardless of whether they were distributed or reinvested in the business.

How Different Types of LLC Equity Are Taxed

Ownership Interests 

LLCs typically offer two types of ownership interests: membership interests and profits interests. Membership interests represent ownership in the LLC, entitling members to a share of profits and losses, as well as voting rights. Profits interests, on the other hand, provide a stake in future profits but not necessarily in the current value of the company.

Taxation of Membership Interests 

By default, an LLC with multiple members is taxed as a partnership. This means that income, deductions, and credits flow through to the individual members’ tax returns based on their ownership percentages. Members pay taxes on their share of the LLC’s profits, regardless of whether they are distributed. 

Taxation of Profits Interests 

Profits interests are often used as incentives for employees or new partners. They entitle recipients to a share of future profits and appreciation in the value of the company. Taxation of profits interests can be complex and depends on various factors, including when the interest vests and whether Section 83(b) elections are made. 

Generally, the recipient isn’t taxed upon receipt of the profits interest but is taxed when the interest vests or is ultimately sold or redeemed.

Capital Contributions 

Members may contribute capital to the LLC in exchange for ownership interests. These contributions aren’t taxed, as they represent investments in the business rather than income. However, the tax treatment may vary if the contributed property has appreciated in value.

Distributions 

When an LLC distributes profits to its members, the tax consequences depend on whether the distribution is considered a return of capital or a share of profits. Return of capital distributions aren’t taxed; they’re considered a return on the member’s investment. Profit distributions are usually taxed as ordinary income to the members in the year they’re received.

Ways to Avoid Double Taxation

The easiest way to avoid or minimize double taxation is to steer clear of the C corp structure. But if the structure is appropriate for your startup, you can implement other strategies to avoid being double-taxed legally.

Method #1: Place Income Into Retained Earnings

If your business is relatively small, we recommend placing your income into retained earnings instead of paying shares to your shareholders. 

By using this strategy, you can rest easy knowing that your earnings are only taxed at the corporate level. You can also use retained earnings to fund future expansions of your startup.

Method #2: Employ Shareholders

Suppose you and your shareholders depend on your company’s profit for income. If so, the only way you can receive shares without paying your taxes twice is to become an employee.

Salaries are considered deductible expenses for a company. Still, they can be taxed at a personal rate, removing the need for double taxation. So, instead of dividing your profit into shares and allocating them to your shareholders, you can pay them off as salaries.

Method #3: Set up A Separate Pass-through Entity

Creating a separate flow-through entity, like an LLC, is one of the more tedious processes to avoid paying your taxes twice. This method is an effective strategy to get more out of your business structure. 

If you build another LLC, you can use this venture to buy properties and equipment to lease to your main company. Besides helping your corporation avoid double taxes, it creates another source of income for your LLC and a deduction for your company.

Method #4: Elect S Corporation Tax Status

Another effective way to avoid being double taxed is by applying for an S corp tax status.

The IRS grants certain companies S corp tax status since the two entities have the same advantages of limited liability. The only difference is that S corps does not get double taxed by directing their profit to their shareholders.

You can still apply for an S corp election. But remember that switching to this status means having limited shareholders.

Method #5: Take Out A Loan

The IRS won’t treat loans as taxable shares if you decide to take them out of your business. This strategy is a great option for those who don’t have to pay several shareholders.

Keep in mind that the IRS will likely inspect the loan. They’ll check to see if the transaction is not disguised as a dividend and ensure that you’re paying your loans back with a justifiable interest rate.

Method #6: Splitting Profits

You can lessen your company’s double tax obligation by splitting its annual profits by allocating a percentage of your earnings and reinvesting it in your business. You can also hire more people to expand your team and draw additional salaries. 

This approach doesn’t prevent your venture from being double-taxed, but it can help lessen your obligations.

Method #7: Search For Double Taxation Agreements (DTA)

The last approach we recommend is for companies impacted by international double taxation. Double taxation agreements (DTA) are treaties two countries approve to prevent or lessen territorial double taxes.

DTAs are placed to encourage international trade and help prevent multinational ventures from being double-taxed. Typically, the agreement requires tax to be charged in one country and exempt in another. 

For instance, Australian shareholders of an American venture must pay their taxes in their home country and are exempted from paying taxes in the US. 

On the other hand, some shareholders are imposed to pay taxes in the country where the profit is generated and will be given foreign tax credits in their homeland. 

Navigate Your Taxes With Ease & Avoid Double Taxation

Undeniably, there’s only so much a C corp can do to avoid being double-taxed. The most effective way a business can protect itself from this is by restructuring the business for an advantage.

NCH’s business formation specialists will help you explore various business structures and determine the right alternative for your startup. Our team of tax specialists can also provide a helping hand in understanding international double taxation policies. 

Know more about taxes and get more resources when you visit our blog here.

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.