1. How to Form an LLC
2. How Limited Liability Companies (LLCs) are Taxed
3. Income Taxes: Single-Owner LLCs

Tax liability for LLC depends on the formation and taxation election, but every LLC is responsible for paying taxes on its income. Similar to other business entities, LLCs operate under state-specific laws.

How to Form an LLC

One of the requirements when forming an LLC is drafting the articles of organization. The articles must be filed with the Secretary of State, Department of Commerce, or other appropriate state agency with the required filing fee.

In most states, the process of forming an LLC is fairly easy. You may be able to fill in the blanks on a pre-printed form to provide the important information about your company. Some states offer a sample form. When an LLC has more than one owner, called a member, you will need an operating agreement. Even though an operating agreement isn't a requirement in most states, it is smart to have one on file.

An operating agreement is similar to a contract between all LLC members. It will outline the structure and operations of the business, including the agreed-upon tax structure.

Other information that should be included in the operating agreement:

  • Responsibilities and rights of the members
  • Procedure for adding or removing members
  • How members will make decisions on business issues
  • Percentage of ownership for each member
  • Management structure
  • Tax treatment

Make sure to check with your state of operation to determine whether you need to file the operating agreement as part of the formation process. After establishing the LLC and paying the required filing fee, you may have to pay registration fees to the state on an annual basis. The laws around LLC formation and operation vary between states. Certain states tax LLCs differently than others. Before forming an LLC, it's smart to consult with an experienced accountant or business lawyer who can explain the local rules and regulations.

How Limited Liability Companies (LLCs) are Taxed

An LLC is a federally recognized business formation. When you form an LLC, you can take advantage of the benefit of limited liability protection. Each member is taxed at their personal individual tax rate. As an LLC member, you are not personally responsible or liable for court judgments or unpaid debts of the business. The losses of each member are limited to their individual investments in the business.

An LLC can have one member or as many members as desired. LLC members can be corporations, partnerships, or individuals. The members of the LLC can choose to run the business themselves or hire a manager, referred to as manager-managed. Members can also elect for taxation as a corporation or a partnership. In a single-owner LLC, the taxation options are as a corporation and as a sole proprietorship. An LLC doesn't issue any stock, so the business profits will be divided among members. The members can choose how they wish to divide the profits, eliminating the need to hold regular meetings of shareholders.

Although LLCs do offer a number of advantages, certain businesses are better structured as corporations. For example, if the owners of a company wish to issue stock options to employees to reward them for their hard work, they would need to form the business as a corporation. In certain states, specific business types aren't allowed to form LLCs. These might include insurance companies and banks.

Since an LLC isn't a taxable entity, it doesn't have a separate tax classification under the IRS. Therefore, the IRS allows multi-member LLCs to be taxed as corporations or partnerships. Single-member LLCs are disregarded entities, which means they exist separate from their owners. Income taxation of an LLC depends on the number of members and the election made by the member(s). An LLC doesn't exist as a separate tax entity, like a corporation. Instead, the IRS refers to this type of business entity as a pass-through entity, similar to a sole proprietorship or partnership.

Income Taxes: Single-Owner LLCs

A single-owner LLC is treated as a sole proprietorship by the IRS, which means that the business doesn't have to file a separate tax return or pay taxes on the business income. A sole owner of an LLC must report all losses and profits of the business on Schedule C and submit that form with the annual personal tax return form.

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