Limited liability companies are business entities in the United States. They are similar to that of a Corporation or a Partnership, but they have unique tax characteristics. Forming an LLC provides limited liability protection for its owners (who are called "members"). These members are always taxed at their personal tax rates.
How a limited liability company pays income tax will depend on various factors such as how many members the LLC has, or if the LLC elects to be treated as a different business form for tax purposes.
Starting an LLC can be done easily by registering in your state, and filing Articles of Organization. Then filing fees must be paid. Despite this, the Internal Revenue Service (IRS) doesn't recognize LLCs for tax purposes. Therefore, how is an LLC taxed?
How are Limited Liability Companies Taxed?
Automatically a Limited Liability Company (LLC) is not a separate tax entity like a corporation. Rather, LLCs are what the IRS calls a “pass-through entity.” This is comparable to a partnership or sole proprietorship.
Since we already know that the IRS sees these businesses as pass-through entities, the question may arise about how they pay income tax. Are the members considered the ones to pay income tax? How does taxation work in companies that have more than one member?
Single Owner LLCs
When it comes to single-member LLCs, the IRS always treats them as disregarded entities. It is important to understand this, because it dictates that the LLC is one in the same as the owner when it comes to taxation. Disregarded entities are taxed in the same way as sole proprietorships. This means that all information regarding the income and expenses of the LLC are calculated on a Schedule C. The net income from a Schedule C is then brought over to your personal tax return.
Multi owner LLCs
An LLC that has more than one member will usually pay income tax as though it is a partnership. Although the LLC will not pay taxes directly to the IRS, instead each individual member will pay tax based on each individual share of ownership in the partnership.
Single Member LLCs and Income Tax
The IRS sees the single-member LLC as a disregarded entity. In non-specialist terms, the business and the owner are seen as a single entity for taxation purposes. Because the IRS considers both of these as the same, the taxes levied mirror a sole proprietorship. This method of taxation works by using a prepared Schedule C form. the form contains all the information about the business's income and expenses over the taxable period. Once the Schedule C is ready, the revenue is brought over to the owner's personal taxable income, and taxes are calculated based on this combined figure.
Multiple Member LLCs and Taxes
Most registered LLC are multi-member arrangements, and the taxes are slightly different in this case as well. Any LLC with more than one member pays taxes as if they were engaged in a partnership. The company itself (the LLC) doesn't pay any taxes to the IRS directly. Each partner pays taxes based on the percentage of the income they get from the registered company. As a member of an LLC, you are required to follow several steps to report your income:
- File an information return using IRS form 1065
- Collect a Schedule K-1, which shows each members percentage of earnings from the partnership
- Copy over the Schedule K-1to your Supplementary Income under Schedule E in your tax return
- Make reference to your Schedule E and ensure it's included in your filing documents
In this structure, the business's income filters through (pass-through, as noted above) to the individual members, and those members are then taxed individually. It should be noted that in some jurisdictions, members may also need to pay self-employment tax.
LLCs can choose to elect taxation as either a C-corporation or S-corporation for tax purposes. The voting procedure and consent required to make this change must then be reflected in the LLC operating agreement.
Your LLC can choose to be taxed as a C-corporation by filing Form 8832 with the IRS. If you choose to make this change, your LLC will be required to pay a 21% federal corporate tax rate. You will also be required to pay state and local corporate taxes as well.
If you choose to elect S-corporation tax status, then you can file Form 2553 with the IRS. S-corps are taxed as a pass-through entity, which is similar to an LLC. Despite this, there are differences in how salary and distributions from the business are taxed. To file taxes for an S-corp, you must submit Form 1120S.
Electing corporate tax status won’t affect your LLC in terms of legalities. Your business will still continue to operate as an LLC. You should consult with a tax professional if you think you may benefit from corporate tax status. This income will be taxed differently, and oftentimes corporations are eligible for more deductions and credits.
Tax Deductions for Small Businesses
Generally speaking, a business can write-off or "deduct" business expenses from its income. This deduction results in paying fewer taxes. However, the deductions that the company makes should fall under the "ordinary and necessary" stipulation. Among the most evident of these expenses are:
- Health Benefits
- Equipment and Operating Expenses
- Travel Expenses
- Startup Costs
- Advertising and Promotion
When your business spends, you can deduct (also known as "write off") your legitimate business expenses from your business income. This can greatly lower the profits that you are required to report to the IRS. Deductible expenses include:
- Start-up costs
- Automobile and travel expenses
- Equipment costs
- Advertising and promotion costs
- Office expenses
- Office supplies
- Health insurance premiums
- Business phone bills
- Continuing education courses
In addition to these deductions, as of 2018, businesses may also qualify for new tax exemptions under the Tax Cuts and Jobs Act. An LLC owner can potentially deduct up to 20% of their net income from taxation calculation. There are stipulations for this deduction, including:
- The taxable income must remain below a specific critical limit. If it passes this limit, the deduction changes to 50%of what is paid to employees
- This deduction doesn't apply to certain service-based industries
Other LLC Taxes
In addition to standard income tax, LLC members also need to pay state and self-employment taxes. Any owner that works within the business must pay taxes on their distributive share as self-employment tax. Investors who don't actively contribute to decision-making within the company may be exempt from this self-employment tax. Typically, owners of an LLC pay twice as much employment tax as their employees since they have to match their employee contributions. Most states see taxation the same way that the federal government does - owners need to pay earnings on the income they receive from their businesses. However, in some jurisdictions, additional taxes may apply. In other jurisdictions, companies don't pay tax at all on their earnings. The IRS will also receive self-employment taxes from members of an LLC as part of their tax burden.
In addition to these taxes, some state boards have operating fees that need to be paid annually. The fee may be referred to as "franchise tax," the "annual registration fee," or the "renewal fee." Businesses registered within these states are required to pay these fees to retain their registration. A lawyer could help organize and arrange your tax filing and ensure that you're compliant with all the state laws and regulations regarding taxation.
Typically, the state taxes LLC profits the same way the IRS does. This means that the LLC owners pay taxes to the state on their personal returns. Despite this, the LLC itself does not pay a state tax, it passes through the owner’s personal tax returns.
In some states, there are state income taxes. For example, in the state of California, there is an added tax for LLCs that make more than $250,000 per year. This tax ranges from about $900 to $11,000. There are annual fees in some states. These are called franchise taxes. This fee is around $100 for most states but, as an extreme example, California charges an $800 minimum fee.
Self Employment Taxes
LLC members are not employees, which means contributions to Social Security and Medicare systems are not withheld from paychecks. Instead, as an LLC owner, you will be required to pay self-employment taxes. Any owner who works in or helps manage the business must pay this tax on their share of the profits. If an owner is not active in the LLC, then they may be exempt from paying these taxes.
LLC owners pay twice as much self-employment tax as regular employees because this is typically matched by employers. Despite this, LLC owners are able to deduct half of the total amount from their taxable income. The self-employment tax rate for business owners is 15.3% of all net income.
How LLCs Pay State income tax
Most states tax LLCs in the same way that the IRS does, through personal tax returns. LLCs do not pay state taxes on their own, and it is always passed through to the members. There are a few states that charge LLC taxes based on income, and this is in addition to federal income taxes. Overall though, it is important to understand that LLC owners are responsible for paying their own taxes and explaining deductions on taxable income to the IRS.
The term Limited Liability Company (LLC) may come up in conversation from time to time as a business owner. As online sales portal Shopify informs us, an LLC is a business structure that gives the protection of a corporate system while offering pass-through taxation to its members. It may not be immediately evident what "pass-through" taxation entails. According to Cornell Law School, pass-through taxation simply refers to the fact that the taxes aren't paid by the business but by a member or members of the company. Pass-through entities are like sole proprietorships or partnerships, in that sense. The owners and operators of these business structures pay taxes on the business earnings out of their own income from the company.