How Limited Liability Companies (LLCs) Are Taxed
The profits and losses of the LLC “pass through” to the LLC owners (members), who report this information on their personal tax returns. The LLC does not pay federal income taxes, but some states do charge the LLC a tax.
Income taxes
The IRS treats your LLC like a sole proprietorship or a partnership, depending on the number of members. If you’ve done business as a sole proprietorship or partnership before, you’re familiar with the rules. If not, here are the basics:
Single-owner LLCs
The IRS treats one-member LLCs as sole proprietorships for tax purposes. This means the LLC does not pay taxes or file a return with the IRS.
As the sole owner of your LLC, you must report all profits or losses on Schedule C and submit it with your 1040 tax return. Even if you leave profits in the company’s bank account at the end of the year, you must pay taxes on that money.
Multi-owner LLCs
The IRS treats co-owned LLCs as partnerships for tax purposes. Co-owned LLCs themselves do not pay taxes on business income; instead, the LLC owners each pay taxes on their share of the profits on their personal income tax returns (with Schedule E attached). Each LLC member’s share of profits and losses, called a distributive share, is set out in the LLC operating agreement.
Most operating agreements provide that a member’s distributive share is in proportion to their percentage interest in the business. For instance, if Jimmy owns 60% of the LLC and Luana owns the other 40%, Jimmy will be entitled to 60% of the LLC’s profits and losses, and Luana will be entitled to 40%. If you’d like to split up profits and losses in a way that is not proportionate to the members’ percentage interests, it’s called a “special allocation,” and you must follow IRS rules.
However members’ distributive shares are divvied up, the IRS treats each LLC member as though they receive their entire distributive share each year. This means that each LLC member must pay taxes on their distributive share whether or not the LLC distributes the money to them. Even if LLC members need to leave profits in the LLC, each LLC member is liable for income tax on their share of that money.
A co-owned LLC itself does not pay income taxes, but it must file Form 1065 with the IRS— the same form that a partnership files—as an informational return. The LLC must also provide each LLC member with a “Schedule K-1” which breaks down each member’s share of the LLC’s profits and losses. Each LLC member reports this information on their individual Form 1040, with Schedule E attached.
LLCs can elect corporate taxation
If your LLC needs to retain profits in the company, you may be able to save money by electing corporate taxation. For details, see “Can Corporate Taxation Cut Your LLC Tax Bill?” at the end of this article.
Estimating and paying income taxes
Because LLC members are self-employed business owners, they are not subject to tax withholding. Each LLC member is responsible for setting aside enough money to pay taxes on their share of the profits. The members estimate the tax amount and make payments to the IRS (and usually the state tax agency) each quarter.
Self-employment taxes
LLC members are not employees but self-employed business owners, so contributions to the Social Security and Medicare systems are not withheld from their paychecks. Most LLC owners are required to pay the self-employment tax directly to the IRS.
Owners who work in or help manage the business must pay this tax on their distributive share of profits. However, owners who are not active in the LLC—those who have only invested money—may be exempt from paying self-employment taxes on their share of profits.
Each owner subject to the self-employment tax reports it on Schedule SE, which is submitted annually with their 1040 tax return. LLC owners pay twice as much self-employment tax as regular employees because regular employees’ contributions to the self-employment tax are matched by their employers. The self-employment tax rate for business owners is 15.3% of the first $84,900 of income and 2.9% of everything over $84,900.
Expenses and deductions
You don’t have to pay taxes on money your business spends in pursuit of profit. You can deduct your legitimate business expenses from your business income, which can lower the profits you must report to the IRS. Deductible expenses include start-up costs, automobile expenses, travel and entertainment expenses, and advertising and promotion costs.
State taxes and fees
Most states tax LLC profits the same way the IRS does—it’s reported on personal returns. However, some states do charge the LLC a tax based on the income it makes, in addition to the income tax its owners pay. Some states also impose an annual fee on LLCs. Before forming an LLC, find out if your state charges a separate LLC-level tax or fee, by visiting the website of your state’s Revenue or Tax Department, or by giving them a call.
Can corporate taxation cut your LLC tax bill?
If you regularly need to keep retained earnings in your LLC, you might benefit from electing corporate taxation. Any LLC can be treated like a corporation for tax purposes. After making this election, profits kept in the LLC are taxed at corporate tax rates, and the owners don’t pay personal income taxes on profits left in the company. Once you elect corporate taxation, you can’t switch back to pass-through taxation for five years. You should treat the decision to elect corporate taxation as seriously as you would the decision to convert your LLC to a corporation.
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