What Things Can an LLC Write Off for Business Expenses?
As a self-employed business owner, you may want to reduce your personal liability when it comes to debts incurred by your business and any legal issues the business may face. However, you may not want the complexity of a corporation. There is a viable alternative in the form of an LLC or Limited Liability Company. LLCs are allowed in every U.S. state and have been around as a business structure for more than three decades.
Why Should You Choose an LLC?
As the person who owns a limited liability company, known as a member, you only have a partial liability for the legal issues and debts of your business. There is a limit to the maximum loss you can incur, and that limit is directly determined by the amount of money you have directly invested in the company.
You may notice that this is pretty much the same situation for a corporation. So what makes LLCs so special? Well, when you create a corporation, the management flexibility you enjoyed as a sole proprietorship or partnership is largely gone.
Flexibility with an LLC
With an LLC, the story is different. You still have flexibility. You can have just one member in the LLC, or you can have an unlimited number of members. A member can also be any kind of legal entity. It can be an individual, as in a person, or a partnership, another LLC, or a corporation. The members of the LLC are at liberty to run the company themselves, or they can choose to hire a manager from outside.
You have a few options in how your business is going to be taxed. It could be taxed as a partnership if there are multiple members in the LLC, or it could be taxed as a corporation if you’re the sole member of the LLC. LLCs do not issue stock, which means that the profits will be shared among the members in whatever way the members deem appropriate. That also means there's no need to hold shareholders’ meetings.
Corporation vs LLC
To be fair, there are still situations where outright incorporating makes more sense than forming an LLC. Say you want to have the ability to issue stock to shareholders so that you have a way of rewarding your best employees by giving them stock options. In that case, a corporation will make much more sense than an LLC. There are also rules in some states that stipulate that certain types of companies cannot form LLCs, such as insurance companies and banks.
How do You Form an LLC?
Just like with corporations, the rules for LLCs are stipulated by state law. To start, you need to determine where your LLC is going to be headquartered and draft articles of organization. You will then file them with the department of commerce, the secretary of state, or whatever state office is considered appropriate in your state. You will also probably have to pay a filing fee.
This process is quite easy in most states. The paperwork is typically prepared in a fill-in-the-blank fashion on a printed form that you complete and submit. If your LLC has multiple members, you’ll also have to draft an operating agreement, which works a lot like an agreement in a partnership.
The Operating Agreement
The operating agreement will detail the rights and responsibilities of the members of the LLC. It will also include information such as:
- The percentage of the business owned by each member
- Rules for the management of the business
- Protocol that members will use to make major decisions about the business
- The procedure for adding new members and removing those who want to exit
- Tax treatment that the LLC has opted for
Once your LLC is fully formed and registered, you will probably have to pay annual registration fees to the particular state in which you registered.
What is the Tax Treatment of an LLC?
Because of their nature, LLCs can take advantage of certain tax deductions and credits that would not be available to unincorporated businesses. Most of the expenses that are related to the operation and ownership of an LLC can be deducted as business expenses for tax purposes.
The Costs of Starting up an LLC
Start-up costs can be claimed by the LLC as business write-offs and can be included in the qualifying expenses that the business incurred in the first year of its operation. Any costs that are not deducted in that first year of operation can instead be amortized over a period of 15 years. The IRS does have rules for what exactly qualifies as a start-up cost.
Qualifying expenses should be incurred or paid off right before the business began. Such costs include salaries for new employees who are still in training, business advertising and market analyses, among others. Any fees paid for professional services like consultants can also be deducted.
Expenses Related to the Property and Location
Business location expenses are deductible for tax purposes by an LLC. If the owner or owners of the LLC operate it from a home office, then such things as supplies and a phone meant specifically for business qualify as business expenses that can be written off. The LLC can also deduct any rent it has paid for property that it does not own.
The LLC cannot, however, write off any personal utilities and mortgage payments as business expenses. If part of a rental home is used for business purposes, such as by setting up an office, then the LLC should be able to deduct the portion of the rent that applies to that part of the home for tax purposes.
The LLC can write off the cost of property used in the business, including office equipment, computers and furniture. A depreciation schedule should be prepared for these, and they should be written off over time.
Expenses Related to Travel and Transportation
Any expenses incurred as a result of transportation and travel qualify to be deducted as business expenses. Expenses related to transportation include such things as visits to customers and clients, travel to business meetings that are away from the LLC's regular headquarters or main place of operations, and so on.
Expenses related to travel include the mileage costs associated with overnight or local travel as well as bus, train or airplane costs. Meal costs, lodging and certain expenses related to entertainment for business purposes that are incurred are also deductible for tax purposes.
LLC Tax Deductions
LLCs also enjoy tax credits for certain kinds of expenses. A tax credit is different from a tax write-off in the sense that it is subtracted from the tax paid by the business, while tax write-offs are LLC tax deductions from the taxable amount. Ultimately, they both serve the same purpose of reducing the tax liability of a business.
The IRS allows tax credits for companies that use renewable fuel sources or alternative motor vehicles. LLCs may also qualify for tax credits for expenses related to the employers and employees, including social security paid by the employer on behalf of the employee, Medicare taxes and child-care services that are provided by the employer.
The Difference Between Corporation, LLC, & Partnership
What type of business structure you choose--corporation, LLC and partnership--has a tremendous effect on how a business affects your personal assets and tax obligations. Until recently, you could only choose between forming a corporation or partnership, but the relatively new structure of LLC is the best of both worlds. In general, the LLC structure has supplanted corporations and partnerships.
Until 1977, corporations and partnerships were the only ways a business could structure itself, according to Michael Spadaccini of Entrepreneur Magazine. In 1977, Wyoming passed the first LLC law. By 1996, every state allowed the formation of an LLC.
Corporations exist mainly to shield shareholders and owners from the liabilities of the company. Corporations pay for this privilege because profits are taxed both at the corporate level and on dividends, according to the Electric Law Library.
Partnerships are like the opposite of a corporation. At least one person must be responsible for company debts and litigation, but profits go directly to owners--avoiding the "double taxation."
Limited liability corporations offer limited liability protection to owners and members, and profits go directly to the members. Because an LLC is essentially the ideal business structure, many new businesses form as one.
Partnerships are very easy to form--two or more people form a partnership when they work together, whether or not they acknowledge it, according to Entrepreneur Magazine. Also, partnerships have almost no formal requirements, such as holding meetings.
Corporations are a very old type of business so the legalities of them are well known. They can issue stock, which makes raising capital easier than with a partnership or LLC. The S corporation structure can avoid the double taxation in some circumstances, such as when the S corporation pays out all profits to shareholders as salary.
LLCs, like partnerships, require few formalities, such as member meetings. Also, this structure is ideal for small businesses for tax purposes.
Disputes in partnerships may arise without a formal agreement, such as how to split the profits, according to Entrepreneur Magazine. Also, each partner retains liability for the other partner's actions no matter what the case.
Corporations must hold annual shareholder meetings. This structure is not ideal for small companies because of the annual filing fees.
Since an LLC cannot issue stock, an LLC might find it hard to attract multiple investors, because investors usually want some physical certificate as proof of ownership. Certain types of businesses, such as banks, cannot form an LLC, according to Gaebler.com.
As of 2010, the IRS does not recognize the entity of LLC, according to the IRS website. In 1988, however, the IRS changed its code so LLCs could be taxed as a partnership. In fact, an LLC can choose whether it wants to be taxed as a corporation or partnership.
Tax Deductions for an LLC Business
Limited Liability Companies (LLC) are by default most often taxed as partnerships or sole proprietorships, which means income is reported on the individual tax returns of LLC members, as owners are called. Because of that, besides being subject to income tax, profits distributed to each member will be subject to self-employment tax to cover Social Security and Medicare benefits. Normal personal deductions do apply, however, along with common business deductions. The LLC business structure also offers special tax advantages.
Flexible Tax Choice
The Internal Revenue Service (IRS) does not recognize an LLC for tax classification purposes, so there is no federal tax deduction unique to an LLC. But an LLC does offer specific tax advantages: "pass-through" taxation that avoids the double tax of corporate profits, and a choice on how to be taxed. For a single-member LLC, the company is a "disregarded entity" indistinguishable from the owner, and taxed as a sole proprietorship. Similarly, multimember LLCs are generally taxed as partnerships.
In both cases, profits are reported on each member’s personal tax return. The members' share of profits are subject to self-employment tax, but the company itself is not taxed on its total profits, as would happen with a corporation. An LLC can "elect" to be taxed as a corporation, which can produce savings in certain situations by treating profit distributions to members as dividends not subject to self-employment tax. Such a choice, however, can have complicated repercussions, and shouldn’t be made without the advice of an accountant.
Costs of Doing Business
The IRS states business expenses are deductible if they are "both ordinary and necessary." The IRS notes an expense need not be "indispensable" to the business, just one that is commonly accepted in your field of endeavor. For a single-member LLC, these are the costs itemized on Schedule C, Profit or Loss from Business. LLCs with at least two members filing as a partnership must file Form 1065, U.S. Return of Partnership Income. The IRS rules coverings business expenses for LLCs are the same as for all businesses. Most of these expenses are deducted at 100 percent, though there are special rules covering entertainment and travel.
Home Office Deductions
Since LLCs are favorites of small businesses, the home office deduction can provide a significant tax savings. The IRS insists the space designated as a home office must be used exclusively for conducting business. Home office deductions are based on the percentage of a home used to conduct business, and applied against the expenses of a home, such as mortgage interest, insurance, rent and utilities.
A home office that takes 15 percent of the space of a home, for instance, can deduct 15 percent of the costs of maintaining the home. A free-standing structure, such as a garage converted to a studio, can also be eligible for a home-office deduction.