Before and once you form your Texas LLC, do not fall victim to the many misconceptions that surround taxes with a limited liability company. It is true that LLCs have a great deal of flexibility regarding their structure and type of taxation. To make the most of the LLC tax benefits, however, you need to be familiar with them.
The Role of Pass-through Taxes
Perhaps the most common misconception is that it makes more sense to form your LLC in a state without income tax instead of Texas. On the surface, this seems like a logical way to reduce the amount of taxes that you pay. In reality, however, pass-through taxation makes the location where you form your LLC more or less irrelevant in terms of taxes. As such, you might as well form your LLC in Texas if that is where you will be operating.
Knowing that pass-through taxes make your LLC's formation location semi-irrelevant for taxes is one thing, but understanding why is another. Pass-through taxes refer to when the earnings of a company go to your private income statements. Essentially, the company itself will not pay taxes on its earnings. Instead, the owner or owners pay taxes on their income from those earnings.
The result is that no matter where your LLC is located, you will pay the tax rate of your own state of residence. That is why it does not matter where you form your LLC. Whether you form it in Texas or New Mexico, the company's profits will pass through and instead of paying corporate taxes, profits appear on your personal taxes.
The pass-through taxation is actually a very nice benefit for LLCs since it prevents double taxation. Essentially, you will not have to pay a corporate tax on the company's profits as a whole and then pay yet another tax on the portion of those profits that make it to your income. The lack of double taxation is more than enough benefit to make up for not being able to limit taxes by forming your LLC in another state.
Types of Pass-through Taxes
By default, an LLC will be classified as a pass-through in terms of taxation. A limited liability company with a single membership is automatically regarded as an entity that is disregarded. Those with multiple members get treated like partnerships. In the case of these partnerships, your LLC does not pay any taxes. Instead, it submits the K-1 form, which the IRS receives. This form outlines the income that the IRS should expect to see reported on the owner's returns.
Changing Classification
If you wish to do so, you can change the type of taxation of your LLC. This would be to an S-Corp or Subchapter-S, which is a different type of pass-through classification. Your accountant will be able to let you know if changing the classification makes sense for you.
If you do wish to change the classification, keep in mind that this can only be done one time every five years. You do have a full 75 days following receiving your EIN to change your company's classification and have it applied retroactively.