LLC Taxation IRS: Everything You Need to Know
LLC taxation IRS differs, depending on how many owners — or members — the company has. By default, LLCs are taxed as partnerships or sole proprietorships when they're created. 3 min read
LLC taxation IRS differs, depending on how many owners — or members — the company has. By default, LLCs are taxed as partnerships or sole proprietorships when they're created. However, business owners may choose other classifications (as long as they're eligible) if they find them more beneficial.
Income Taxes for Single Owner LLCs
Single-member LLCs are considered disregarded entities, meaning that the business and the owner are legally separate entities. For tax purposes, the IRS treats single-member LLCs as sole proprietorships. The business itself isn't responsible for federal taxes, so it doesn't file a tax return with the IRS.
If you're the sole owner of an LLC, you'll report all of your business profits and losses on Schedule C and include it with your 1040 return. You'll file a return as a sole proprietor.
If you choose to leave profits in the LLC bank account at the end of the year, you're still required to pay income tax on them. You might choose to leave profits for the following reasons:
- To expand the company
- To cover future expenses
Income Taxes for Multiple Owner LLCs
For tax purposes, the IRS treats multi-member LLCs as partnerships. As with single-member LLCs, multi-member LLCs aren't taxed themselves. Instead, the LLC's members file individual tax returns where they pay taxes according to their share of the company's profits.
In an LLC's operating agreement, the distributive share — the share that each member holds in profits and losses — should be clearly defined. In most cases, distributive shares are in proportion to how much interest a member has in the company. If you choose to divide profits and losses in another way — that is, not in proportion to members' percentage interests — it's a special allocation.
Although an LLC doesn't pay income taxes as a business, it still files form 1065. This is an information return, and the IRS reviews it to ensure that all members in an LLC are giving accurate accounts of their income. Form 1065 is strictly for informational purposes. Individual owners use it to report all credits, income, and deductions.
LLCs also give each member a Schedule K-1, which details each member's share of business profits and losses, and members submit their Schedule K-1 with form 1065.
There's a specific rule for LLC members who don't actively participate in the business (the equivalent of limited partners): they only pay taxes on compensation received from the LLC for services provided, so they're not responsible for paying self-employment taxes on the business profits that they receive.
Should You Be Taxed as a Corporation?
In most cases, business owners choose the tax form that benefits them the most financially.
At the high end of the tax table, the tax rate for partnerships and sole proprietorships is more than the highest corporate tax rate. If you fall in this high tax bracket, as a sole entrepreneur or partner, you might decide to separate your personal taxes from your business.
The main benefit of being an LLC that's taxed as a corporation is not being required to take all business income on your own return. For instance, say your business has a net profit of $50,000 at the end of the year. If you're the sole owner, you take all of the profit on your individual tax return. If you choose to have your business taxed as a corporation, however, you can keep some or all of the profit (keeping it in the business), so you don't have to pay personal income tax on it.
One disadvantage for being taxed as a corporation is being subject to double taxation. You'll pay taxes on the business income as well as income you receive as dividends. You'll have to carefully weigh the savings of electing corporate status. Otherwise, it may not be worth it if double taxation winds up costing you more than you save.
Because taxes can be a complex area, many business owners find it beneficial to hire tax experts, such as CPAs and financial advisers. You may want to consult with them before choosing another tax status to ensure you're making the smartest move for your business.
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