LLC Pass Through Taxation: Everything You Need to Know
LLC pass through taxation is one of the main benefits of an LLC business structure, and it is why LLCs are so popular amongst small businesses.3 min read
LLC pass through taxation is one of the reasons a person might file an LLC. This is one of the main benefits of this type of business structure, and it is why LLCs, or “limited liability companies,” are so popular amongst small businesses.
What Is a Limited Liability Company?
An LLC is a type of business structure that provides its owners with personal liability protection from the LLC’s financial debts and legal liabilities. This essentially means that if the LLC owes an obligation to a creditor, the creditor cannot come after the personal assets of the LLC’s owners, such as their house, car or other personal belongings. While the personal assets are protected, the LLC owners can lose the money they invested in the LLC. Hence, they are only subject to “limited” liability.
There are very narrow situations where a court will “pierce the corporate veil,” and allow the LLC’s creditors to legally go after the personal assets of the members. These situations include where the LLC member(s):
- Acted negligently or unethically
- Personally guaranteed a business loan and the LLC defaults
- Treats the LLC as merely being an extension of their personal affairs, as opposed to a legally distinct, separate business entity.
In order to provide more protection for the LLC’s members’ personal assets, they can take out a liability insurance policy. A good policy can protect the members’ personal assets when the limited liability protection cannot. It can also protect personal assets when the limited liability protection status is rejected by a court.
What Is “Pass Through” Taxation?
The Internal Revenue Service (“IRS”) considers a limited liability company a pass through entity, similar to a partnership or sole proprietorship. A pass through entity essentially means that the LLC’s profits and losses are passed through to the owner’s personal tax returns. Thus, the LLC itself does not file its own tax returns, but rather the owners only pay taxes on the business once. This is one of the biggest advantages of forming an LLC.
If an LLC only has one member, the IRS will treat it like a sole proprietorship for tax purposes. The owner must then report all of the LLC’s profits and losses on Schedule C and submit it with their personal tax returns.
If the LLC has two or more members, the IRS will tax it like a partnership. Similar to an LLC that is solely owned, multi-member LLCs do not pay taxes on the LLC’s incomes, but rather pays taxes on their share of the profits on their personal tax returns. LLCs with multiple members must file Form 1065 with the IRS. This form is used by the IRS to ensure that the LLC’s owners are properly reporting their income.
How Are LLC Members Taxed?
Unlike a corporation, members of an LLC are considered self-employed business owners rather than employees of the LLC. As such, taxes are not withheld from their paychecks, but they are responsible for paying self-employment taxes on their share of the LLC’s profits. Every quarter, they must make payments to the IRS and the applicable state tax agency. The self-employment tax rate is 15.3 percent of the LLC’s net income, plus an addition 2.9 percent for any income above a certain threshold.
LLC members are still allowed to deduct business expenses from their personal tax returns, which can drastically decrease the amount of profits reported to the IRS. Expenses that qualify for deductions include business travel, inventory costs, initial startup costs and promotion expenses.
In addition, LLC owners may now be eligible for a new tax deduction specifically for pass through entities. This new tax deduction was created by the Tax Cuts and Jobs Act and allows a single member LLC or multi-member LLC to deduct up to 20 percent of the net income from the LLC.
LLCs can also choose to be taxed like a corporation. If this is the case, the LLC will be charged a flat rate of 21 percent on their profits, just like a corporation. The 21 percent corporate tax rate is lower than any of the three individual income tax rates, which would otherwise apply to LLC members.
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