Key Takeaways:

  • LLCs enjoy pass-through taxation, avoiding double taxation by passing profits and losses to members' personal tax returns.
  • LLCs can be taxed as sole proprietorships, partnerships, or corporations, depending on the number of members and IRS elections.
  • Pass-through taxation offers simplicity but also requires owners to pay self-employment taxes and make estimated quarterly payments.
  • Members may qualify for the 20% qualified business income (QBI) deduction under the Tax Cuts and Jobs Act.
  • Additional tax obligations include state-level pass-through taxes, franchise taxes, and entity classification elections.

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 Pass-Through Taxation Works in Practice

In practical terms, LLC pass through tax treatment means the business itself is not taxed separately at the entity level. Instead, the income “passes through” directly to the owners, or members, who report it on their personal tax returns using the applicable IRS forms (e.g., Schedule C for single-member LLCs, Schedule K-1 for multi-member LLCs).

This structure avoids the double taxation commonly seen in traditional C corporations, where income is taxed at both the corporate and shareholder levels. Instead, members only pay tax once, at the individual level, based on their share of the business income. However, they are also personally responsible for income tax and self-employment tax on these earnings, unless the LLC elects corporate taxation.

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.

State-Level Taxes and LLC Pass-Through Treatment

Although the IRS provides pass-through treatment at the federal level, some states impose entity-level taxes or special requirements on LLCs. For example:

  • California imposes an annual minimum franchise tax of $800, regardless of LLC income.
  • Tennessee and Texas apply franchise or gross receipts taxes on LLCs.
  • Some states allow or require composite returns for nonresident LLC members, simplifying state filings but potentially increasing tax owed.

It’s crucial for LLC owners to check state-specific regulations to avoid surprises and ensure compliance with both federal and state tax laws​.

Electing Corporate Taxation for an LLC

LLCs can elect to be taxed as a C corporation or S corporation by filing Form 8832 or Form 2553, respectively. This can be beneficial in certain circumstances:

  • C Corporation Election: May be advantageous for reinvesting profits back into the business. Income is taxed at a flat 21% corporate rate, but distributions (dividends) are taxed again at the individual level.
  • S Corporation Election: Retains pass-through taxation but may reduce self-employment tax liability by allowing owners to pay themselves a reasonable salary and take additional profits as distributions.

Electing a different tax status can offer planning flexibility, but it also comes with increased administrative requirements and potential legal implications. Business owners should consult a tax professional before making these elections​.

Additional Considerations for Pass-Through Entities

When operating as a pass-through entity, LLC members should be aware of several additional factors:

  • Quarterly Estimated Taxes: Because taxes aren’t withheld from LLC distributions, members must make estimated payments to the IRS and, where applicable, to state tax agencies.
  • Qualified Business Income Deduction (QBI): Under the Tax Cuts and Jobs Act, eligible LLC owners may deduct up to 20% of qualified business income, reducing overall tax liability.
  • Limitations on Deductions: Some deductions may be subject to thresholds or phaseouts based on income level or the nature of the business.

Proper recordkeeping and tax planning are essential to optimize deductions and ensure accurate filings​​.

Frequently Asked Questions

1. What is LLC pass-through taxation? Pass-through taxation means an LLC’s income is taxed on the owners' personal tax returns instead of at the business level.

2. Do all LLCs automatically receive pass-through tax treatment? Yes, by default. Single-member LLCs are taxed as sole proprietorships and multi-member LLCs as partnerships unless an election is made.

3. Can an LLC choose to be taxed as a corporation? Yes. An LLC can elect to be taxed as a C corporation or S corporation by filing IRS forms 8832 or 2553.

4. Are LLC owners subject to self-employment tax? Generally, yes. LLC members must pay self-employment tax on their share of profits, unless they elect S corp taxation and receive part of their income as distributions.

5. Does pass-through taxation apply to state taxes? Not always. Some states impose separate taxes or fees on LLCs even if they’re treated as pass-through entities at the federal level.

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