Tax Treatment of LLC: Everything You Need to Know
Understanding tax treatment of LLC can help you determine whether to establish one in your state. Since 1980, LLCs have been recognized in all states.3 min read
2. Which Forms Do I Need to File?
3. Single-Member LLC Income Taxes
4. Multi-Member LLC Income Taxes
Understanding tax treatment of LLC businesses can help you determine whether to establish one in your state. Limited liability companies are relatively new business entities that have been recognized in all states since 1980. An LLC combines characteristics of a startup, sole proprietorship or partnership, and corporate-style liability protections.
How Are LLC Members Taxed?
Unlike a corporation, an LLC is not a separate taxable entity. Instead, the IRS considers LLCs “pass-through” entities. All business profits and losses pass onto the owners, who are called members. Each member then reports this financial information on their personal tax return. How the LLCs net income is divided up among multiple members depends on their share as stated in the company's operating agreement.
For example, if your LLC made $20,000 profit during the last taxable year, you will pay taxes on your share of that profit. If your LLC has two members, you will both pay $10,000 in taxes.
However, if you have a single-member LLC, you alone are responsible for paying taxes on all company profits.
The main features to keep in mind about LLCs is that they:
- Do not pay federal taxes themselves
- Are hit with annual taxes in some states
- Provide a lot of flexibility when it comes to deciding how you want your business taxed
The IRS automatically classifies your LLC as a sole proprietorship (single-member LLC) or partnership (multi-member LLC). If you don't like this default classification, you can select a different tax status by filing the appropriate forms with the IRS.
Before deciding how your business should be taxed, consult with your accountant and an attorney to help you run what-if scenarios based on your locality.
Which Forms Do I Need to File?
Every LLC must have an operating agreement, even if your state doesn't require it. An operating agreement outlines the rights and responsibilities of each member as well as the company's management and tax structures. Check with your Secretary of State's office to see if filing your operating agreement is required.
After creating your LLCs operating agreement, you should file IRS Form 1065. The IRS uses this document to make sure each member of the LLC is accurately reporting their income. In addition, give each member a copy of Form 1065 so they can view their shares in the company profits and losses. This makes it easier for members to file their individual 1040 returns.
Single-Member LLC Income Taxes
Single-member LLCs are not regarded as taxable entities. In other words, the company and the owner are separate entities, so the IRS treats single-member LLCs as sole proprietorships for tax purposes. With a single-member LLC, the company itself doesn't pay taxes or file a tax return.
Similar to a sole proprietorship, you can file your tax return on Schedule C, which states your net income. Remember, as the sole owner of your business, you must report all profits and losses on Schedule C and file it along with your 1040 tax form even, if you reinvest some of the money into the business or leave some of the profits in the company's bank account.
Multi-Member LLC Income Taxes
The IRS categorizes multi-member LLCs as partnerships for tax reasons. Like single-member LLCs, multi-member LLCs do not owe taxes on the business's behalf. Instead, each owner pays taxes on their share of the profits. They must report this information on their personal tax returns and attach a Schedule E form.
Each member's distributive share, or share of the profits and losses, should be outlined in the LLCs operating agreement so there's no confusion. Most business owners divide each member's share based on how much interest percentage they own in the business. In other words, if you invested 60 percent of the money to fund your LLC and your partner only put up 40 percent, you each own a 60 percent and 40 percent share, respectively.
You may choose to divide shares in a way not proportionate to your interest percentages, but you must state this special allocation in your LLCs official documents.
Regardless of how your shares are divided, each member must pay taxes on their whole share even if the company doesn't distribute any money to its members. For example, if you leave some of your share in the business to buy inventory, you are still taxed on that portion as profit.
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