How LLC's are Taxed
Like the owners of sole proprietorships and partnerships, LLC owners report business income and losses on their personal tax returns. An LLC is not a separate taxable entity like a corporation. It is what the IRS calls a “pass-through entity,” like a partnership or sole proprietorship. All of the profits and losses of the LLC “pass through” the business to the LLC owners (called members), who report this information on their personal tax returns.
The IRS treats an LLC like a sole proprietorship or a partnership, depending on the number of members in the LLC.
Single Member LLCs
The IRS treats single member LLCs as sole proprietorships for tax purposes. The LLC itself does not pay taxes and does not have to file a return with the IRS. The sole owner of the LLC reports all profits (or losses) of the LLC on Schedule C and submits it with his 1040 tax return. Even if the owner leaves profits in the company’s bank account at the end of the year (for instance, to cover future expenses or expand the business), he must pay taxes on that money.
Multiple Member LLCs
The IRS treats co-owned LLCs as partnerships for tax purposes. Co-owned LLCs themselves do not pay taxes on business income. Instead, the LLC owners each pay taxes on their lawful share of the profits on their personal income tax returns (with Schedule E attached). Each LLC member’s share of profits and losses, called a distributive share, is set out in the LLC operating agreement. Most operating agreements provide that a member’s distributive share is in proportion to his percentage of interest in the business. For instance, if Bill owns sixty percent of the LLC and Bob owns the other forty percent, Bill will be entitled to sixty percent of the LLC’s profits and losses, and Bob will be entitled to forty percent. If the members want to split up profits and losses in a way that is not proportionate to the members’ percentage interests in the business, it’s called a “special allocation,” and they must carefully follow IRS rules. However members’ distributive shares are divided up, the IRS treats each LLC member as though the member receives his or her entire distributive share each year. This means that each LLC member must pay taxes on his or her distributive share, whether or not the LLC actually distributes the money to the members. Even if LLC members need to leave profits in the LLC ( for instance, to buy inventory or expand the business) each LLC member is liable for income tax on the member’s rightful share of that money. Although a co-owned LLC itself does not pay income taxes, it must file Form 1065 with the IRS. This form, the same one that a partnership files, is an informational return that the IRS reviews to make sure the LLC members are reporting their income correctly. The LLC must also provide each LLC member with a Schedule K-1 which breaks down each member’s share of the LLC’s profits and losses. In turn, each LLC member reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.
LLCs Can Elect Corporate Taxation
If your LLC will regularly need to retain a significant amount of profits in the company, you (and your co-owners, if you have any) may be able to save money by electing to have your LLC taxed as a corporation.
Estimating and Paying Income Taxes
Because LLC members are not considered employees of the LLC, but rather self-employed business owners, they are not subject to tax withholding. Instead, each LLC member is responsible for setting aside enough money to pay taxes on that member’s share of the profits. The members must estimate the amount of tax they’ll owe for the year and make quarterly payments to the IRS (and to the appropriate state tax agency, if there is a state income tax) in April, June, September, and January.
Because LLC members are not employees but self-employed business owners, contributions to the Social Security and Medicare systems (collectively called the “self-employment” tax) are not withheld from their paychecks. Instead, most LLC owners are required to pay the self-employment tax directly to the IRS.
The current rule is that any owner who works in or helps manage the business must pay this tax on his distributive share. However, owners who are not active in the LLC, that is, those who have merely invested money but don’t provide services or make management decisions for the LLC, may be exempt from paying self-employment taxes on their share of profits. The regulations in this area are a bit complicated, but if you actively manage or work in your LLC, you can expect to pay the self-employment tax on all LLC profits allocated to you. Each owner who is subject to the self-employment tax reports the amount due on Schedule SE, which is submitted annually with the 1040 tax return. LLC owners (and sole proprietors and partners) pay twice as much self-employment tax as regular employees, since regular employees’ contributions to the self-employment tax are matched by their employers. The current self-employment tax rate for business owners is 15.3% of the first $87,000 of income and 2.9% of everything over $87,000.
Expenses and Deductions
You don’t have to pay taxes (income taxes or self-employment taxes) on money that your business spends in pursuit of profit. You can deduct or “write off” your legitimate business expenses from your business income, which can greatly lower the profits you must report to the IRS. Deductible expenses include start-up costs, automobile mileage or expenses, travel and entertainment expenses, equipment costs, and advertising and promotion costs.
State Taxes and Fees
Most states tax LLC profits the same way the IRS does. The LLC owners pay taxes to the state on their personal returns but the LLC itself does not pay a state tax. A few states, however, do charge the LLC a tax based on the amount of income the LLC makes, in addition to the income tax its owners pay. In addition, some states impose an annual LLC fee that is not income-related. This may be called a “franchise tax,” and “annual registration fee” or a “renewal fee.” Before forming an LLC, find out if your state charges such a separate LLC tax or fee. You should be able to find this at the website of your state’s secretary of state, department of corporations, department of revenue, or tax commission.
Can Corporate Taxation Cut Your LLC Tax Bill?
If you regularly need to keep a substantial amount of profits in your LLC (called “retained earnings”), you might benefit from electing corporate taxation. Any LLC can be treated like a corporation for tax purposes by filing IRS Form 8832 and checking the corporate tax treatment box on the form. After making this election, profits kept in the LLC are taxed at the separate income tax rates that apply to corporations; the owners don’t pay personal income taxes on profits left in the company. Unlike an LLC, a corporation pays its own taxes on all corporate profits left in the business. Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to most LLC owners, this can save you and your co-owners money in overall taxes. For example, if your retail outfit needs to stock up on expensive inventory at the beginning of each year, you might decide to leave $50,000 in your business at year’s end. With the regular pass-through taxation of an LLC, these retained profits would likely be taxed at your individual tax rate, which is probably at least 25%. But with corporate taxation, that $50,000 is taxed at the lower 15% corporate rate. Once you elect corporate taxation, however, you can’t switch back to pass-through taxation for five years, and if you do switch back, there could be negative tax consequences. In other words, you should treat the decision to elect corporate taxation as seriously as you would the decision to convert your LLC to a corporation.