A limited liability company (LLC) is not a corporation. Instead, the IRS designates an LLC as a pass-through entity, essentially a non-taxable entity.
So, how is an LLC taxed? The answer to this question is not simple or straightforward and depends on varying factors. Here is a comprehensive overview of how LLC taxes work at the federal and state levels, as well as tips to prepare for the next tax season.
How is an LLC tax? Two Variations
The IRS designates LLCs as pass-through entities similar to sole proprietorships (single-member LLCs) and partnerships (multi-member LLCs). Here is an overview of how each structure is taxed:
Taxes for Single-Member LLCs
The IRS regards and treats a single-member LLC as a sole proprietorship. The reasoning behind this is that the LLC's owner pockets the business's profits, regardless of whether or not they transfer the money to their personal accounts. The LLC's owners pay themselves via distributions drawn from the business, hence the 'pass-through entity' designation.
The single-member LLC's owner pays taxes on the business's profits on their 1040 tax return. The tax return should include one or more of the following schedules, depending on the business's nature:
- Schedule SE – to pay self-employment tax (required)
- Schedule C – to report business income (required)
- Schedule E – to report income from investments and rental property (optional)
Ideally, you must pay self-income tax on the distributions with which you pay yourself. However, you don't have to pay income tax on the distributions since you already paid income tax on the LLC's profits.
Taxes for Multi-Member LLCs
The IRS regards multi-member LLCs are partnerships. Ideally, the LLC comprises at least two members. Members can participate in the business's operations or limit their role to investment, essentially sitting on the sidelines and getting a share of the profits.
The multi-member LLC's owners and members draw distributions for their income from the business's profits, and each member pays taxes on these distributions when filing their personal tax returns. The members' tax returns may include the following schedules:
- Schedule SE – to pay self-employment tax
- Schedule C – to report business income
- Schedule E – to report income from investments and rental property
- Schedule K-1 – to report your share of the profits as an individual owner or member
Although the LLC is not required to pay taxes, it is still required to file Form 1065. Form 1065 is an informational report of the LLC's profits and losses, and the IRS uses it to determine whether the individual members' tax reports are correct.
It is worth noting that all members must include Schedule E in their tax reports since the LLC is essentially an investment from which they draw profits. However, not all members are required to file Schedule SE or pay self-employment taxes. Ideally, only the members actively involved in the LLC's operations are required to pay self-employment taxes. But the law regarding this issue is complex.
LLC Tax Deductions & State Taxes
The IRS doesn't tax LLCs, but some states do. Some of the common state taxes for LLCs include:
- Franchise Tax – an annual fee for the LLC to operate in the state, regardless of its income or profitability.
- Sales & Use Tax – a tax levied on your physical products, paid by your customers when they purchase your physical products and collected and remitted to the state by you.
Some states also tax LLCs depending on their income. For example, California levies LLCs that make more than $250,000 a tax of $900 to $1,100.
Regarding tax deductions, LLCs don't have to pay income and self-employment taxes on most of the business's expenses. You can deduct legitimate business expenses from the LLC's income, thereby reducing its taxable profits. Some common and legitimate business expenses that qualify as LLC tax deductions include:
- Startup costs
- Equipment costs
- Advertising costs
- Travel expense
Notably, LLC owners can also make significant savings via the Tax Cuts and Jobs Act. The act allows LLCs to deduct 20% of their net income before taxation. Deductions and state taxes may prove complex, and proper bookkeeping is critical to filing taxes properly.
Should You Consider Corporation Taxes?
LLC owners can save some money on their income and self-employment taxes by electing their businesses to be taxed as C or S corporations. This usually makes financial sense when you compare the difference between a corporation and individual income tax rates.
C corporations are taxed under a flat rate of 21% on their profits. In contrast, LLC owners and members are taxed under a variable income tax rate ranging between 32% and 37% of their income. Overall, you can save at least 11% of your taxes by electing to be taxed as a C corporation.
However, electing the LLC to be taxed as a C corporation creates the risk of double taxation. Essentially, the business pays corporate taxes, and you pay capital gains taxes on any dividends received from the business. Fortunately, C corporations offer opportunities to access tax-advantaged fringe benefits, including stock options and ownership plans.
You can also elect to have the LLC taxed as an S corporation. An S corporation requires the LLC's owners and members to become employees for taxation purposes, saving them money on self-employment taxes. It is advisable to solicit professional tax services when determining the right model for your LLC.
Frequently Asked Questions (FAQs)
Q: Is an LLC business model good for taxation purposes?
A: An LLC's most notable benefit is the pass-through taxation model allowing all of the profits to go to the owners and members. However, LLC owners and members pay higher taxes on the income from their businesses than they would if the LLC was a C or S corporation.
Q: Should I file my personal and LLC taxes together or separately?
A: This will depend on the LLC's business structure. You can file the taxes together for a single-member LLC, but you must file a separate Schedule K-1 and Form 1065 for a multi-member LLC.
Q: How can I convert my LLC into a C or S corporation?
A: You can elect your LLC to be taxed as an S corporation by filing Form 2553. Alternatively, you can elect it to be taxed as a C corporation by filing Form 8832.
Get Your Taxes Right!
LLCs risk hefty fines and other severe legal consequences for errors with their tax returns. Fortunately, you don't have to worry about your LLC tax returns with Hiline at your service.
Hiline is a premium, tech-enabled accounting company that offers comprehensive bookkeeping and tax services. We help business leaders focus on what matters: their business. When it comes to filing taxes, we've got you covered. Get in touch today to learn more about our services and how we can help.
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