Key Takeaways

  • LLCs are not taxed as separate entities by default and instead use pass-through taxation.
  • By default, single-member LLCs are taxed as sole proprietorships; multi-member LLCs are taxed as partnerships.
  • LLCs can elect to be taxed as an S corporation (via Form 2553) or C corporation (via Form 8832).
  • Tax filing requirements depend on classification: Schedule C (sole proprietorship), Form 1065 and Schedule K-1 (partnership), Form 1120 (C corp), or Form 1120S (S corp).
  • LLC members must pay self-employment tax unless classified as an S corp and the member is paid a reasonable salary.
  • State tax obligations and fees vary widely and may include annual franchise taxes or gross receipts taxes.
  • LLCs may face additional taxes such as excise tax, sales tax, or state unemployment insurance tax.

Understanding taxes on an LLC is important when establishing a new business. Unless you elect otherwise, single-member LLCs are taxed as sole proprietorships, while multiple-member LLCs are taxed as partnerships.

Reasons to Form an LLC

A limited liability company is a type of business which protects its owners, who are called members, from personal liability for company debts and lawsuits. LLCs are recognized in all states, but each state has a different way to classify LLCs for the purpose of state taxes. One of the great things about LLCs is that this business structure provides liability protections to owners who are only taxed at their own personal tax rates.

As an LLC, you are only liable for the amount you personally invested in the company, not for court judgments or unpaid debts against the business. The same can be said of corporations, but LLCs provide more management flexibility than corporations, allowing you to have a single member or an unlimited number of members. LLC members can be individuals or other businesses, including corporations.

Since LLCs don't issue stock, company profits are divided among members. If you decide to reward essential employees with stock options, however, you will need to incorporate your business.

Forming an LLC

Limited liability companies are regulated by individual states, so you need to abide by state laws when establishing your business. In general, you should create an Articles of Organization document and file it with the appropriate state office. Most Secretary of State websites provide a downloadable form to help you simplify this process.

If your LLC will have more than one member, you should also create an Operating Agreement. An Operating Agreement should outline:

  • Each member's responsibilities and rights
  • Each member's stake in the business
  • How members will make decisions on important issues
  • How the business will be managed
  • Procedures for adding or removing members
  • Which tax treatment the LLC selects

After establishing an LLC, you may be required to pay an annual registration fee in your state.

LLC Taxation

An LLC is not technically recognized as a taxing entity by the IRS. Instead, LLCs are sanctioned by individual state laws, giving LLC members a lot of flexibility when it comes to paying taxes. LLCs are considered “pass-through” tax entities because the tax burden passes onto the owners, allowing members to avoid the double taxation corporations are subjected to.

You can choose to have your LLC taxed one of several ways to help save money. By default, an LLC is taxed either as a sole proprietorship or partnership depending on how many members it has. A single-member LLC must file Schedule C for the member's personal tax return. A multi-member LLC should file Form 1065, and each member should fill out Schedule K-1.

By default, LLCs do not pay taxes on business profits. Instead, each owner pays their share on their personal tax return. It's important to outline each member's distributive share, or share of the profits and losses, in the LLCs Operating Agreement. Most members agree that distributive shares are based on each individual's interest percentage in the company, although this method isn't required.

Regardless of a member's distributive share, the IRS treats each owner as if they receive their entire share every year. This means that you must pay taxes on your whole share, even if the company doesn't distribute all of the money to members. This means that even if some of your profit shares go back into the business for the purpose of expanding or buying inventory, you are still liable for that amount of income tax.

For example, let's say your LLC has two members. The LLC has a net income of $100,000 for the year. If you both share the business equally, you will pay taxes on $50,000 and so would your business partner.

There are, however, other tax options for LLCs. For instance, you may elect to be taxed as a corporation.

Before being taxed as a corporation, you must notify the IRS by filing Form 8832: Entity Classification Election. When it's time to pay your taxes, you should fill out Form 1120 or the 1120-A short form.

In general, you must also pay self-employment taxes directly to the IRS because Social Security and Medicare are not automatically withheld from your paycheck.

Federal Tax Election Options for LLCs

LLCs are not locked into their default tax classifications. Instead, they have the flexibility to elect to be taxed as a corporation.

  • C Corporation Election:
    LLCs can file IRS Form 8832 to elect corporate tax treatment under Subchapter C. This results in the LLC being taxed as a separate entity, and profits are taxed at the corporate level using Form 1120. Distributions to members are then taxed again as dividends, which may lead to double taxation.
  • S Corporation Election:
    Alternatively, an LLC may file Form 2553 to be taxed as an S corporation. This allows the LLC to continue pass-through taxation, but members can be treated as employees and paid a reasonable salary, which reduces the amount subject to self-employment taxes.

Choosing between these classifications should be based on projected income, desired compensation structures, and potential tax advantages.

Self-Employment Tax and Reasonable Compensation

LLC members are generally subject to self-employment taxes (15.3%) on business earnings, covering Social Security and Medicare. This applies to default classifications (sole proprietorship or partnership).

However, if the LLC is taxed as an S corporation, only the member's salary is subject to self-employment taxes. Distributions beyond the salary are not, which can offer significant savings. Still, the IRS requires that member-employees be paid a reasonable salary to prevent abuse of this structure.

State and Local Tax Obligations for LLCs

In addition to federal taxes, LLCs are subject to varying state and local taxes depending on the jurisdiction in which they operate. These may include:

  • Annual Franchise Taxes: A flat fee or a percentage of revenue in states like California, Delaware, and Texas.
  • Gross Receipts Taxes: Some states levy taxes on gross income rather than net income.
  • Sales and Use Taxes: LLCs that sell taxable goods or services must collect and remit sales tax.
  • State Employment Taxes: If the LLC has employees, it may need to pay unemployment insurance taxes and withhold income taxes at the state level.

Owners should verify state-specific filing requirements and deadlines, as failure to comply can result in penalties or suspension of business privileges.

LLC Tax Filing Requirements by Classification

The filing obligations for an LLC depend on its tax classification:

  • Sole Proprietorship (Single-member LLC): File Schedule C with Form 1040.
  • Partnership (Multi-member LLC): File Form 1065 and provide each member with Schedule K-1.
  • C Corporation: File Form 1120 and pay corporate taxes directly.
  • S Corporation: File Form 1120S and issue Schedule K-1s to shareholders.

LLCs may also need to file additional forms, such as Schedule SE for self-employment taxes or Form 941 for employment taxes. Keep thorough financial records throughout the year to simplify compliance and optimize deductions.

Frequently Asked Questions

1. How is an LLC taxed by default?

By default, a single-member LLC is taxed as a sole proprietorship and a multi-member LLC is taxed as a partnership. Both use pass-through taxation.

2. Can an LLC be taxed as a corporation?

Yes. An LLC can elect to be taxed as a C corporation (Form 8832) or an S corporation (Form 2553), depending on its business needs.

3. Do LLC members pay self-employment tax?

Yes, unless the LLC elects S corporation status. In that case, only the member’s salary is subject to self-employment tax.

4. What tax forms does an LLC need to file?

It depends on classification: Schedule C (sole proprietorship), Form 1065 and K-1s (partnership), Form 1120 (C corp), or 1120S and K-1s (S corp).

5. Are there state taxes for LLCs?

Yes. States may impose annual franchise fees, sales tax, employment taxes, and more, depending on your LLC’s activities and location.

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