How Is an LLC Taxed: Everything You Need to Know
LLC are not recognized by the IRS as a taxable entity, so they must choose a specific taxation status, either corporation, partnership, or disregarded entity. 4 min read
How is an LLC taxed? Limited Liability Companies (LLCs) are not recognized by the IRS (Internal Revenue Service) as a taxable entity, so they must choose a specific taxation status, either corporation, partnership, or disregarded entity. This chosen status will determine how the LLC is taxed.
The Basics of an LLC
LLCs are a type of business structure that is recognized in every state, but the requirements and regulations are different depending on the state. This business structure offers liability protection for the business owners as well as pass-through taxation.
Business owners will need to determine the right taxation identity for their LLC. They can choose from:
- Corporation (for an LLC with more than one member)
- Partnership (for an LLC with more than one member)
- Sole proprietorship or disregarded entity (for an LLC with only one member)
Corporations are taxed as their own entity, so the business itself pays income tax, and the owners are taxed on any shares they take home. This is called double taxation and is considered a disadvantage to the corporation structure.
Partnerships and disregarded entities benefit from pass-through taxation. This means that the income of the business passes through to its owners and is reported on their personal income tax returns. The LLC itself is not taxed.
Single-Member LLC Taxation
A single-member LLC is automatically treated as a sole proprietorship, or disregarded entity, by the IRS. This allows the LLC not to be required to file its own tax return. The business owners will still need to inform the IRS of the company's income for record-keeping and checks. The IRS wants to be sure that the owners are reporting the correct amount on their personal returns.
The owner of a single-member LLC will file a Form 1040 return with a Schedule C form attached. Any money that is left in the business account and not absorbed by the owner will still be taxed.
Disregarded entities are viewed as businesses that are separate from their owners in the eyes of the IRS.
Multi-Member LLC Taxation
Multi-member LLCs are automatically classified as partnerships by the IRS unless the business owner elects corporate status. LLCs treated as partnerships are also allowed pass-through taxation. Each of the owners pay taxes on the shares that they are responsible for according to their ownership percentage. The company itself is not taxed.
Owners of a multi-member LLC being taxed as a partnership will file a Form 1040 with a Schedule E attached. The shares that each of the owners take home, also called the distributive share, should be accurately reported with their personal income tax returns. These percentage amounts should also be spelled out clearly in the business's operating agreement.
Usually, LLCs decide that the distributive shares allocated to each of the members will reflect their capital contributions to the business. LLCs, however, have the freedom to allocate shares differently. If a member's capital contribution was a certain amount, but they took on additional management duties, they could be awarded a higher distributive share than someone with the same capital contribution, which is called special allocation. The corporate structure does not allow this kind of freedom when deciding on ownership percentages.
Even though the business itself is not taxed, the owners still need to file a Form 1065 to inform the IRS of the company's income. Each of the owners should be given a Schedule K-1 form which tells them exactly what their distributive shares amounted to for the year, and this number is what they need to report with their personal income taxes on the Schedule E form.
LLC Self-Employment Taxes
The members of an LLC are not considered employees, so they are not taxed as employees. This means that the LLC members are required to pay self-employment taxes to the IRS which include:
- Social security taxes
- Medicare taxes
Only LLC members who are active in the running of the company are required to pay these taxes. Sometimes LLCs will have members who are only members in name but are not involved in the day-to-day operations of the business. These nominal members usually do not need to pay self-employment taxes.
The members of an LLC will be required to pay two times as much tax for self-employment taxes than is required by the company's employees. These members also are allowed to deduct half of what they pay in self-employment taxes from their income taxes, which can help make up for this additional amount.
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