The voices of Tax Policy Center's researchers and staff
In our house, the holiday season doesn’t just mean cookie baking and gift shopping. It’s also an early start to the tax season, with receipt organizing and tax estimating.
For the past ten years, I’ve been a sole proprietor who pays taxes using personal income tax returns. That pass-through business status was easy enough to establish. I just started paying the self-employment tax on my income. I also take deductions for my home office and other business expenses and make pre-tax contributions to a one-participant 401k plan.
I thought I had it all figured out, but I’d never considered establishing an LLC (limited liability company). An LLC is one of several business structures one can use to have a separate legal entity for business-related liabilities and to protect personal assets from business disputes. LLCs have been growing as a share of all non-farm sole proprietorships since 2001, now accounting for nearly 10 percent of them (or 2.78 million LLCs out of 28 million non-farm sole proprietorships as of 2020).
Five of my friends and family members are a part of that group. That’s enough to generate a little LLC FOMO (fear of missing out). Should I join them?
What does it take to form an LLC?
I would need to follow more state and federal requirements. Here in Michigan, a sole proprietor establishing an LLC would need to choose a unique business name, file articles of organization, pay a $50 filing fee, draft an operating agreement, obtain an Employer Identification Number (EIN), register for Michigan taxes, secure any required licenses or permits, open a business bank account, and fulfill annual compliance requirements.
The same EIN would be used to file federal income taxes, including any required forms like a Schedule C for a sole proprietor to report profits and losses. LLCs must also withhold and pay federal employment taxes for their LLC employees and pay any applicable excise taxes.
Are there tax benefits with an LLC?
Yes, but they are no different from a sole proprietorship like mine. The Tax Cuts and Jobs Act of 2017 (TCJA) introduced the 20 percent qualified business income deduction (QBID) for pass-through entities whose income is reported on personal income tax returns. Those include sole proprietorships, partnerships, S corporations, and LLCs.
Let’s take my situation as an example. If I manage to earn $100,000 in a year, I could deduct 20 percent of the qualified business income, or $20,000, and pay taxes on the remaining $80,000. Assuming a tax rate of 24 percent, I could save $4,800 in taxes, owing $19,200 instead of $24,000 on the full $100,000. (Things can differ for married people filing jointly, who must file either Form 8995-A or file Form 8995.)
My consulting business as a writer is not explicitly identified as a Specified Service Trade or Business, for which there are income thresholds beyond which the deduction starts to phase out. I know that because my TPC colleagues deciphered and explained 182 pages of QBID rules.
My colleague Steve Rosenthal highlights that while this deduction can be lucrative, it's also regressive. “Most employees are out of luck, and many high-income owners of service businesses… get an unexpected tax break.”
TPC’s Howard Gleckman seconds that. He decries the provision’s further complication of the tax code for businesses. The rules pick winners and losers, which, as Howard says, “is nuts.”
The QBID is set to expire at the end of 2025, like many provisions of the TCJA. Of course, Congress could extend the QBID in its current form or with amendments. Debate over extension is underway. Proponents of the deduction say it encourages the growth of eligible firms and helps treat pass-through businesses more comparably to corporations. Critics argue that there’s no evidence that the QBID has actually increased investment or job growth by pass-through firms. It’s costly, too: The Joint Committee on Taxation estimates the QBID will lead to a $258 billion revenue loss between fiscal year 2022 and fiscal year 2026.
There is no one-size-fits-all pass-through structure.
Whatever Congress does with the QBID, choosing the right entity for business income requires careful thought. The scale of my business is small, both in risk and reward.
It might not make a substantive difference if I established an LLC. If I did, I might want to hire an accountant, and that cost might outweigh the other benefits. Filing a form incorrectly or incompletely in a given year could result in my owing thousands of dollars to the IRS. This just happened to a friend with an LLC.
For others (especially those with accountants), an LLC structure could make a lot of sense. The tax code recognizes several different pass-through structure options. It’s up to business owners to learn about them and discover what works best for their circumstances.
The Tax Hound, publishing once a month, helps make sense of tax policy for those outside the tax world by connecting tax issues to everyday concerns. Have a question or an idea? Send Renu an email.
Posts and comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.
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