How are LLCs Taxed? | Everything You Need To Know
A limited liability company (LLC) is a business structure formed to protect the personal assets of its owners from liability. This means that LLCs have to pay taxes to stay compliant with state law and not get fined for failing to do so.
According to the Internal Revenue Service (IRS), limited liability companies (LLCs) represented a significant majority (71.7%) of all partnership returns filed in the United States for the year 2021. This marks the 20th consecutive year that LLCs have dominated in the number of partnership returns filed, highlighting their continued importance in the business sector.
There are many different types of taxes an LLC can be required to pay, depending on how the IRS classifies them.
As a seasoned legal professional with a track record of assisting numerous companies in the realm of LLCs, I'll go over how LLCs are taxed and what kind of tax obligations each type has so you know how best to plan your finances accordingly.
Quick Summary
- LLCs have flow-through taxation, meaning income and expenses pass directly to individual members' tax returns, avoiding corporate taxes.
- Income taxes for LLCs vary based on single or multi-member ownership, with losses deductible from personal income.
- According to the Internal Revenue Service (IRS), limited liability companies (LLCs) represented a significant majority (71.7%) of all partnership returns filed in the United States for the year 2021.
- From my experience, how you file and pay income taxes is based on whether your LLC has single or multiple owners.
How to Treat an LLC for Tax Purposes?
Based on our experience, an LLC is not taxed as a separate business entity. Instead, the income and expenses pass through from the company to the individual members' tax returns each year.
The process is known as flow-through taxation, which means that all profits or losses are passed on directly to its members without being subject to corporate taxes.
Some states charge a yearly LLC fee that is not based on income. This might be referred to as an "annual registration fee" or "franchise tax."
The cost in most states is around \$100, but some states have high fee rates.
However, how you choose your business structure will determine how your company is taxed.
LLCs and Income Taxes
There are numerous business taxes that an LLC's owners may be obligated to pay. The majority of business owners face the most difficulty with federal, state, and local income taxes.
From our experience, how you file and pay income taxes is based on whether your LLC has single or multiple owners.
In terms of financial performance based on IRS, LLCs were responsible for 25.5% of the total profits generated by partnerships in 2021, an increase of 23.1% over the profits recorded in 2019. This underscores the economic impact LLCs have within the partnership framework.
States tax LLC profits separate from their owners' incomes. If a sole-member LLC makes a profit for the year after deducting business expenses, the owner will owe taxes to the IRS at his or her individual income tax rate.
If the company has a loss for the year, the owner can deduct it from their personal income.
In a multi-member LLC, for example, an LLC has two owners with a 50-50 share ownership split; each owner is responsible for half of the profits paid in taxes.
Each owner may also claim half of the credits and tax deductions that the LLC qualifies for and deduct half of its losses.
This form of taxation is very similar to that used by partnerships.
The IRS requires a multi-member LLC to submit various tax forms, including Form 1065, U.S. Return of Partnership Income—an annual informational return that you must submit to the IRS [1].
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LLC Taxed as a Corporation
LLC owners can choose to be taxed as a corporation or partnership by electing corporate LLC tax treatment with the IRS.
Drawing from our experience, the LLC is taxed like a regular corporation, and profits are passed through to members' personal income taxes on their individual returns each year.
If you have an LLC that qualifies for S Corporation taxation status in your state, it can pass its net profit or loss to its members' personal tax returns each year, with the business itself not taxed.
The owners of an LLC electing corporate taxation will be required to file Form 1120 after filing their federal income taxes as a means of electing S Corporation status [2].
However, if they divide their earnings between salary and distribution, they are still subject to self-employment taxes.
You'll continue to pay self-employment tax on the portion of your income that is deemed as salary. Still, you'll only have to pay ordinary income tax on the portion that is designated as a distribution.
Electing corporate taxation also means you can opt for a C corporation, which would probably involve double taxation.
LLC Taxed as a Sole Proprietorship
A single-member LLC is rather similar to a sole proprietor because it's considered one for federal income tax purposes.
This means that the LLC owner reports the LLC's profits and business expenses (advertising and promotion costs, for example) on Schedule C of their personal federal Form, submitted along with the 1040 tax return.
In our experience, we found that there isn't a separate taxation form or schedule used by single-member LLCs as they are taxed like any other sole proprietorship.
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How Are LLC Members Taxed?
LLC owners (LLC members) pay income taxes differently, depending on their elected taxation and structure.
For LLC tax purposes, the IRS considers one-member LLCs sole proprietorships, which implies the LLC itself does not pay taxes and is not required to file an income tax return with the IRS.
Single-Member LLC Taxes
As the LLC's only owner, you must disclose all LLC income (or deductions) on Schedule C. Schedule C must be submitted with your 1040 tax return.
Even if you leave money in the company's bank account at the end of the year to cover future costs or develop the business, you must pay income tax on that money.
Your SMLLC will automatically be treated as a sole prop unless you file for an S or C corporation.
To file as a C corporation, you will need to file IRS Form 8832 to report all business income and file form 1040 for personal income.
Form 2553 is filed upon electing S corporation while your business income is reported on 1120S form.
Multi-Member LLC Taxes
LLC owners conducting business through multi-member LLC owners pay taxes as a partnership.
From our experience, co-owned LLCs, like single-member LLCs, do not pay taxes on business profits; instead, the LLC owners each pay taxes on their portion of the profits on their personal income tax returns.
The distributive share of profits and losses, known as a distributive share in an LLC agreement, should be defined in an LLC operating agreement.
A co-owned LLC must file Form 1065 with the IRS, even if it does not pay its own taxes. This form is an informative return that the IRS checks to ensure that LLC members report their earnings correctly.
The LLC must also deliver each member of the LLC with a Schedule K-1, which breaks down each member's portion of the organization's earnings and losses.
Each LLC member reports this information on his or her individual Form 1040, along with a Schedule E attachment.
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- How Much Does It Cost to Start an LLC
- How to Get Health Insurance for LLC Owners
FAQs
Do LLCs Get Tax Refunds?
In general, LLCs can't get tax refunds. However, LLCs elected C corporations for tax purposes can receive tax refunds, provided that they make quarterly estimated installments higher than their annual tax liability.
How Much Should an LLC Set Aside for Taxes?
On average, limited liability companies should set aside from 15% to 40% of the LLC's profits. This amount should be enough to cover both state and federal taxes.
Can I File My LLC and Personal Taxes Separately?
No, LLCs are pass-through entities, which means they can't pay separate federal taxes. As a result, the company's profits are taxed on your personal tax return at your individual bracket.
Can an LLC Choose Its Tax Classification?
Yes, an LLC can choose its tax classification by filing an election with the IRS. By default, a single-member LLC is taxed as a disregarded entity, while a multi-member LLC is taxed as a partnership. However, an LLC can elect to be taxed as a corporation, which may impact how the owners pay personal income taxes and self-employment tax on business income.
References
- https://www.irs.gov/forms-pubs/about-form-1065
- https://www.irs.gov/pub/irs-pdf/f1120.pdf
