How Are LLCs Taxed: Everything You Need to Know
To understand how are LLCs taxed, you must first understand how the IRS classifies the business,Single-member LLCs may be taxed like sole proprietorships.3 min read
2. Profits and Losses
3. Business Expenses
To understand how are LLCs taxed, you must first understand how the IRS classifies the business. Single-member LLCs may be taxed like sole proprietorships, while others may be taxed as partnerships. In addition, some LLCs choose to be treated as a different business structure for tax purposes.
How LLCs Are Taxed
Unlike a corporation, a Limited Liability Company, or LLC, isn't considered a separate tax entity. LLCs are similar to sole proprietorships or partnerships, in that they're “pass-through entities.” All of an LLC's profits and losses go through the business to the business owners, or members. Members then report this information when they file individual tax returns.
Your LLC won't be taxed at the federal level. However, depending on your state, the state may tax the LLC. Your LLC is treated differently by the IRS, depending on how many members it has.
For tax purposes, single-member LLCs are treated as sole proprietorships. The LLC pays no taxes itself, so it doesn't file a federal tax return. You, as the LLC's sole owner, are responsible for reporting all profits and losses on Schedule C and submitting it with a 1040 return. If you have profits in your business account at the end of the year — for the purpose of expanding the business, for instance — you have to pay taxes on that money.
For tax purposes, the IRS treats multi-member LLCs as partnerships. Multi-member LLCs don't pay taxes on business income, but each member is taxed on his or her share of business profits. They report this information on their individual tax returns.
The amount of profits and losses that each member is responsible for is known as a distributive share. Your operating agreement details the distributive share for each member. In most cases, the distributive share that members hold is in proportion to their percentage interest in the company.
Profits and Losses
If you choose to allocate profits and losses in another way — that is, not in proportion to members' percentage interest — this is a “special allocation.” The IRS has specific rules on how to handle these allocations, which you must follow.
The IRS assumes that each member of an LLC receives a distributive share every year, so the government expects each member to pay taxes on that share, even if the LLC doesn't distribute the money to the member. The importance of this rule is that should LLC members choose to leave profits in the business — for the purposes of expansion or buying inventory — each member still has a tax responsibility on his or her rightful share of those profits.
Multi-member LLCs don't pay income taxes, but they still file form 1065. The business also has to give each member a Schedule K-1, which shows the member his or her share of business profits and losses. The member then reports this information on an individual form 1040, along with Schedule E.
LLC members are viewed as self-employed business owners, not company employees. They're responsible for setting aside money to cover tax payments on their share of the profits. Members must make quarterly, estimated tax payments to the IRS. The self-employment tax includes their contributions to Medicare and Social Security.
Members pay this to the IRS instead of having it withheld in a paycheck, and they report their self-employment taxes on Schedule SE.
You don't have to pay taxes on money that your LLC spends in order to make a profit. These are considered business expenses that you can write off, so they can help lower the amount of profits your company reports to the government.
The types of expenses that you may be able to deduct include the following:
- Advertising and promotion
- Start-up costs
- Automobile expenses
- Travel and entertainment expenses
In most states, LLCs pay taxes the same way they do to the IRS — members pay on their individual tax returns. The business itself isn't taxed. Some states, however, charge taxes based on the income an LLC makes.
Taxes can be a complicated area. If you need help understanding business taxes, you should consult with tax and/or legal professionals. it's important to follow all state and federal rules regarding taxation so that you face no financial or legal hassles in the future.
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