IRS and LLC: Everything You Need to Know
When considering the relationship between the IRS and LLC, you should know that the LLC is considered a disregarded tax entity by the IRS.3 min read updated on February 01, 2023
When considering the relationship between the IRS and LLC, you should know that the LLC is considered a disregarded tax entity by the IRS. The IRS makes this designation because an LLC functions as a "pass-through" tax entity similar to a partnership or a sole proprietorship. In a "pass-through" entity, no taxes are paid at the business level. The profits from the LLC pass through to the members to report on their personal tax return.
While an LLC does not have to pay federal taxes, it may be required to pay an annual tax depending on the laws of the state in which it was formed. When taxing an LLC, the IRS determines whether the LLC is treated as a sole proprietorship or a partnership, depending on the number of members the LLC has.
Tax Considerations for LLCs
Important things to consider about the IRS when filing taxes for your LLC include:
- If the LLC has a single member, then the LLC is taxed as though it is a sole proprietorship. In other words, the LLC does not pay taxes and the profit and losses are reported on the lone member's Schedule C of their personal tax return. Even if you plan to put the profits back into the company, you still have to pay taxes on those profits.
- If the LLC is owned by multiple members, they are treated by the IRS as a business partnership with regard to taxation. The LLC still does not pay taxes at the business level, but the profits and losses pass through to the members who then are responsible for paying taxes on the profit and losses of their portion of the business. Each member does this on their personal tax return by attaching a Schedule E.
- When dividing profits among multiple members, the shares should be distributed in accordance with the terms set forth in the Operating Agreement. If so desired, the losses of the company can be split differently than the profits are distributed; this action is referred to as a special allocation.
- Once the shares are split according to the company's Operating Agreement, taxes are assessed by the IRS on the members' distributed share. Members are required to pay taxes on their distributed share even if they do not take their distributions that year. Therefore, even if an LLC member leaves the money in the business or purchases inventory or items for the business with their distribution, that money is still subject to tax liability.
- Even though an LLC does not have to pay federal taxes, it is required to file a company tax return or a Form 1065 with the IRS. The form is an informational tax return that the IRS can refer to in order to make sure that each member is paying their proper portion of the taxes. When completing the Form 1065 return, each owner receives a Schedule K-1, which provides complete detail of each member's share of profits or losses that they need to report on their personal tax return.
- An LLC may consider opting for corporation taxation, which can be the best option if a business is expected to have a substantial amount of earnings. To be treated as a corporation for taxation, your business needs to file a Form 8832, Entity Classification Election, and choose corporate tax treatment on the form. As of 2018, all regular c corporation tax entities pay 21 percent flat tax on all of the company's profits. This flat tax rate can be attractive if members' personal tax brackets are in one if the three upper tiers, in which they might pay 32 percent or higher tax rates.
- An LLC member is considered by the IRS to be a self-employed owner instead of an employee of the company, so they are not subject to tax withholding from their pay. Instead, each member pays taxes on their share of the profits via their personal return. To avoid penalties for underpayment of taxes, members are required to pay the taxes on their profit on a quarterly basis, with payments due in April, June, September, and January.
If you need help with information about the IRS and LLC, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.