Taxes on an LLC: Everything You Need to Know
Understanding taxes on an LLC is important when creating a new business.3 min read
2. Forming an LLC
3. LLC Taxation
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.
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.
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