Key Takeaways

  • An LLC taxed as a partnership offers pass-through taxation benefits while protecting owners from personal liability.
  • Single-member LLCs are taxed as sole proprietorships unless another election is made.
  • Multi-member LLCs are automatically taxed as partnerships but must file IRS Form 1065.
  • Special allocations of profits and losses must be clearly documented and justified to the IRS.
  • LLCs can elect corporate taxation for better retained earnings strategies.
  • Members must make estimated quarterly tax payments to the IRS and possibly their state.

An LLC taxed as a partnership is an option for business owners who want their company to be taxed as a partnership but receive the benefits of a limited liability company (LLC). By default, the IRS treats all LLCs with one member as sole proprietorships for tax reasons. This means the business doesn't have to pay taxes on losses and gains. It also doesn't have to file a separate tax return with the IRS.

Single-Owner LLC Taxes

The sole owner of an LLC is responsible for reporting all business losses and profits on Schedule C and filing it with his or her personal 1040 tax return form. Even if the business retains some of its profits at the end of the year, such as to grow the business or cover future expenses, the owner must pay income taxes on all remaining funds.

Eligibility and Flexibility for Single-Member LLCs

Single-member LLCs have flexibility in how they are treated for federal tax purposes. While default treatment classifies the LLC as a sole proprietorship, owners can also choose to file Form 8832 to elect taxation as a corporation. This flexibility allows the owner to optimize tax benefits based on business growth and future plans​. Importantly, unless the LLC files to be taxed differently, all income and losses will pass through to the owner's personal income tax return​.

Multi-Owner LLC Taxes 

The IRS treats LLCs with more than one owner as partnerships. Similar to single-owner LLCs, multi-owner LLCs do not have to pay taxes on profits or losses. The business owners must report their profit shares on their personal tax returns and pay required taxes on those amounts. Multi-member LLC members report their profits and losses on Schedule E.

An LLC's operating agreement should clearly outline every member's share of the business losses and profits. This share is referred to as a distributive share. Operating agreements often state that a member's distributive share is directly proportional to his or her percentage of interest in the LLC. If members choose to distribute losses and profits in a manner that isn't proportional to membership and business interests, this is referred to as a special allocation.

Regardless of how the LLC divides shares of profits and losses among its members, the IRS will still treat each member as if he or she received the entire distributive share during the previous year. As a result, the LLC members are required to pay the full amount of taxes on the entire distributive share at tax time every year, even if the business didn't distribute profits to its members. 

Although multi-owner LLCs don't have to pay income taxes, these businesses are required to file IRS Form 1065 each year. Form 1065 is also filed by partnerships and includes information that the IRS can review to make sure the LLC's members reported all income correctly. Limited liability companies are also required to provide all members with a Schedule K-1. This document includes a breakdown of each member's share of the business losses and profits. 

Members will then report the information outlined on the Schedule K-1 on their own personal tax form 1040 and attach Schedule E, another required form.

Pass-Through Taxation and Special Considerations for Multi-Member LLCs

LLCs with multiple members benefit from "pass-through" taxation, meaning the business itself does not pay income tax. Instead, profits and losses are passed through to each member based on their ownership percentage or according to a special allocation outlined in the operating agreement​.However, the IRS scrutinizes special allocations to ensure they have substantial economic effect. If members disproportionately assign profits or losses without valid economic reasoning, the IRS may reallocate them based on ownership interests​.Additionally, multi-member LLCs must file an annual information return (Form 1065) and provide a Schedule K-1 to each member​.

Consider Electing Corporate Taxation

When a business needs to keep a large portion of its profits within the company, referred to as retained earnings, it might make sense to elect for taxation as a corporation. Limited liability companies can elect for taxation as corporations by filing Form 8832 with the IRS, which is the Entity Classification Election. On this form, simply check the corporate tax treatment box to elect for corporation taxation.

After filing this form, the next step is deciding how to be taxed, with two options:

To elect taxation, the LLC owner(s) must file an election form with the IRS. After filing the required forms, the IRS will treat the LLC as if it was a corporation. The business must then file all tax forms required of corporations.

Comparing S Corporation and C Corporation Elections

When choosing to be taxed as a corporation, LLC owners have two primary options:

  • C Corporation: The LLC becomes a separate taxable entity and must pay corporate income taxes. Any distributions made to owners (dividends) are taxed again at the individual level, creating "double taxation"​. However, C corporations allow unlimited shareholders and greater flexibility in profit retention.
  • S Corporation: Allows profits and losses to pass through directly to members’ personal income taxes, avoiding double taxation. To qualify, the LLC must meet strict requirements, including having no more than 100 members and only issuing one class of stock​.
    Careful evaluation of the business’s needs, projected income, and growth strategy can help determine which election offers the most tax advantage.

Estimating and Paying Income Taxes

Limited liability company members are considered to be self-employed owners of businesses, not LLC employees. Therefore, they aren't subject to tax withholdings. All LLC members must do the following: 

  • Set aside enough money throughout the year to pay taxes on their shares.
  • Because the members don't necessarily know how much they will receive at the end of the year, they must make estimates each quarter and make payments to the IRS.
  • If state income tax applies, the members must also make quarterly payments to the proper state agency. These payments must be made every year in April, June, September, and January.

Self-Employment Taxes and Additional Tax Obligations

In addition to regular income tax, members of an LLC taxed as a partnership are responsible for self-employment taxes, which cover Social Security and Medicare contributions​.Members must calculate and pay:

  • 15.3% self-employment tax on net earnings up to the Social Security wage base.
  • 2.9% Medicare tax on earnings above the wage base, plus an additional 0.9% Medicare surtax for high earners.
    Other considerations include:
  • State and Local Taxes: Depending on the state, LLC members may face franchise taxes, gross receipts taxes, or minimum annual fees​.
  • Estimated Tax Payments: Members should base quarterly estimated payments on projected income to avoid penalties. If the business is newly formed, using prior year tax liability as a safe harbor estimate can be a smart approach​.

Frequently Asked Questions

  1. What is the default tax status of an LLC?
    By default, a single-member LLC is taxed as a sole proprietorship, and a multi-member LLC is taxed as a partnership unless a corporate election is made.
  2. What form must a multi-member LLC file annually?
    A multi-member LLC must file IRS Form 1065, the U.S. Return of Partnership Income, along with issuing a Schedule K-1 to each member.
  3. Can an LLC taxed as a partnership make special allocations?
    Yes, but the allocations must have substantial economic effect and be outlined clearly in the LLC operating agreement to be accepted by the IRS.
  4. Why would an LLC elect to be taxed as a corporation?
    Electing corporate taxation allows LLCs to retain earnings within the business and may offer tax planning advantages, particularly for growing companies.
  5. Are LLC members subject to self-employment taxes?
    Yes, members must pay self-employment taxes on their distributive share of the LLC’s income unless the LLC is taxed as a corporation.

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