Key Takeaways

  • LLCs are not taxed as a separate entity by the IRS; instead, owners choose between disregarded entity, partnership, or corporation taxation.
  • Single-member LLCs default to sole proprietorship (disregarded entity) taxation, reporting profits on the owner’s personal return.
  • Multi-member LLCs default to partnership taxation, filing Form 1065 and issuing Schedule K-1s to members.
  • LLC members active in the business must pay self-employment taxes, which cover Social Security and Medicare.
  • LLCs may elect S corporation or C corporation taxation for strategic benefits, such as reducing self-employment taxes or reinvesting profits.
  • State taxes (franchise tax, gross receipts, or excise taxes) and annual fees vary by state and can affect overall costs.
  • LLCs can often lower taxes through deductions, retirement plan contributions, and electing the most advantageous tax classification.

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.

LLC Tax Election Options

Although the IRS does not recognize LLCs as their own tax entity, owners have flexibility in deciding how their LLC will be taxed. The default classifications are:

  • Single-member LLC → Sole Proprietorship (disregarded entity)
  • Multi-member LLC → Partnership

However, an LLC may also elect to be taxed as a C corporation or an S corporation by filing the appropriate forms with the IRS (Form 8832 for C corp election, Form 2553 for S corp election).

  • C Corporation Election: The LLC pays corporate income tax, and distributions to owners are taxed again as dividends (double taxation). This may benefit businesses planning to retain earnings or seek outside investors.
  • S Corporation Election: Profits and losses pass through to owners, but owners can classify part of their income as wages (subject to payroll tax) and the remainder as distributions (not subject to self-employment tax). This can reduce overall tax liability if properly structured.

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.

Recordkeeping and Filing Requirements for Single-Member LLCs

While a single-member LLC does not file a separate federal tax return, the IRS still requires accurate reporting of income and expenses. The owner must:

  • File Schedule C with their Form 1040 to report profits or losses.
  • Pay self-employment tax on net earnings.
  • Keep separate business bank accounts and records, even though the IRS disregards the entity for income tax purposes.

Some states require single-member LLCs to file separate annual reports or pay franchise or excise taxes, regardless of federal tax treatment.

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.

Taxation Flexibility and Special Allocations

Multi-member LLCs are generally taxed as partnerships, but owners may customize how profits and losses are distributed:

  • Proportional Allocation: Distributions reflect each member’s ownership percentage.
  • Special Allocations: Members can agree to distribute profits or losses in a way that does not mirror ownership percentages, as long as it complies with IRS rules and is documented in the operating agreement.

Each member receives a Schedule K-1 showing their share of profits, losses, credits, and deductions. This must be reported on their personal tax returns. Members may also be liable for self-employment taxes on their distributive share unless the LLC has elected to be taxed as an S corporation.

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.

Strategies to Reduce LLC Taxes

LLC owners can lower their tax burden through proactive planning:

  • Deductible Expenses: Operating costs such as rent, utilities, marketing, and professional services can be written off.
  • Retirement Contributions: LLC owners may contribute to SEP-IRAs, Solo 401(k)s, or SIMPLE IRAs to reduce taxable income.
  • Health Insurance Premiums: Self-employed LLC owners may deduct qualifying health insurance premiums.
  • S Corporation Election: For LLCs with consistent profits, electing S corp status can reduce self-employment taxes by allowing a mix of salary and distributions.
  • Entity Restructuring: As the business grows, converting to a C corporation may provide long-term tax or investment advantages.

State-Level LLC Taxes and Fees

Federal taxation is only part of the picture. LLCs are also subject to state-level obligations, which vary widely:

  • Franchise Taxes: Charged annually in states like California and Delaware, often based on income, assets, or a flat fee.
  • Gross Receipts Taxes: Some states impose taxes on revenue rather than profit.
  • Annual Reports and Fees: Most states require LLCs to file annual or biennial reports and pay filing fees.

These state-level taxes and fees apply whether or not the LLC earns a profit, so owners should factor them into their planning.

Frequently Asked Questions

  1. How is LLC taxed by default?
    By default, a single-member LLC is taxed as a sole proprietorship and a multi-member LLC as a partnership, with income passing through to owners.
  2. Can an LLC choose to be taxed as an S corp?
    Yes. By filing Form 2553 with the IRS, an LLC can elect S corporation status, potentially reducing self-employment taxes for active members.
  3. Do LLC owners pay self-employment tax?
    Yes, active members must pay Social Security and Medicare taxes on earnings, unless the LLC elects to be taxed as an S corporation.
  4. Are there state taxes on LLCs?
    Many states impose franchise taxes, excise taxes, or annual report fees on LLCs, regardless of federal tax classification.
  5. How can LLCs reduce their taxes?
    LLCs can lower taxes by claiming deductions, contributing to retirement accounts, deducting health insurance premiums, or electing S corp taxation.

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