From a tax standpoint, limited liability companies are like hermit crabs. With no tax classification of their own, they inhabit the tax homes of other types of businesses, and they can choose and change the way they are taxed.
This tax flexibility is one of the things that make LLCs so appealing for small business owners. But if you’re just starting out, the LLC tax filing process can seem confusing.
LLCs can choose to be taxed like sole proprietorships, partnerships or corporations. It’s important to understand the differences between them because the way your business is taxed can affect both your total tax bill and your obligation to pay self-employment tax.
How are LLCs taxed?
Because LLCs are a relatively new type of business entity, the Internal Revenue Service has not established a tax classification for them. Therefore, while there are forms and procedures for corporate tax returns, there is no such thing as an LLC tax return form.
That doesn’t mean that limited liability company income isn’t taxed. It just means that LLCs are taxed as though they were a different kind of entity.
If your LLC has only one owner (known as a “member”), the IRS will automatically treat your LLC like a sole proprietorship. If your LLC has more than one member, the IRS automatically treats it like a general partnership.
However, if you’d prefer to have your LLC taxed like a corporation, you can change its tax status by filing a form with the IRS.
The single-member LLC tax return
A single-member LLC that is taxed like a sole proprietorship reports its income and expenses on Schedule C of the member’s personal income tax return. The member then lists the net profit or loss on the income section of his or her Form 1040, U.S. Individual Income Tax Return.
Because the LLC is ignored for tax purposes, an LLC that is taxed like a sole proprietorship is referred to as a “disregarded entity.” The entity is only disregarded for tax purposes—these LLCs still retain all of their limited liability protection.
Multi-member LLCs taxed like partnerships
If your LLC has more than one member and is taxed like a partnership, the LLC's income will flow through to the members themselves and will be reported on their personal tax returns.
Specifically, an LLC that’s taxed like a partnership files Form 1065, an informational tax return that reports all of the partnership’s income and expenses.
The LLC also issues a Schedule K-1 to each LLC member, showing the member’s share of the LLC’s profit. Your LLC’s operating agreement should list each member’s percentage share of the LLC’s profits and losses.
LLC members then report their share of profit (or loss) on Schedule E of their personal tax returns. Members must report and pay tax on their entire share of the profit, even if they leave some of those profits in the business rather than taking them home.
Self-employment taxes and estimated taxes
The members of LLCs taxed as sole proprietorships or partnerships are considered to be self-employed for federal tax purposes. When you work for an employer, your employer pays half of your Social Security and Medicare taxes, and you pay the other half. But when you’re self-employed, you must pay the full amount yourself. On your annual tax return, you are allowed to deduct half of this tax from your income, which slightly offsets the impact of the self-employment tax.
You must file Schedule SE, Self-Employment Tax, with your tax return to report and calculate your self-employment taxes. In addition, self-employed individuals are expected to make estimated payments of these taxes and their personal income tax quarterly throughout the year. Failure to do this can lead to penalties and interest.
LLC taxed as S corp. or C corp.
As an alternative, an LLC can choose to be taxed as a corporation by filing Form 8832, Entity Classification Election, with the IRS.
An LLC can also file a further election to be taxed as an S corporation. Corporate taxation can be more complicated and it’s a good idea to consult an accountant before choosing to be taxed as a corporation. Some of the reasons an LLC might choose corporate taxation include:
- You plan to leave a substantial amount of money in the business each year to finance expansion or for other reasons.
- Your profits are far greater than the amount the owner/employees should reasonably make in salary and you want to minimize self-employment taxes.
An LLC taxed as a C corporation files a corporate income tax return each year. The shareholders also report any salary and dividends they receive on their personal tax returns.
An LLC taxed as an S corporation follows a procedure similar to a partnership, filing an informational return and providing members with a Schedule K-1 form showing their share of the profits (or losses). The members then report that income on Schedule E of their personal tax returns.
Knowing how and when to file estimated and annual tax forms for your LLC is an important step in keeping your business’s finances on track. If you’re just starting out, you’ll probably prefer to be taxed as a sole proprietorship or partnership, but as your business grows, you may want to consult with an accountant to see if your LLC might benefit from taxation as a corporation.
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