How LLC members are taxed? An LLC is interpreted as a pass-through business for federal tax purposes. This means that the LLC itself does not have to pay taxes on its profits.
When it comes to selecting a business entity for your company, taxes are a critical component. The amount of taxes you are required to pay to the government is substantially influenced by how your company is structured. An LLC is a type of firm that is incorporated with the state to provide its owners with personal liability protection.
How do LLC Taxes Work?
For federal income tax purposes, an LLC (Limited Liability Company) is treated as a pass-through entity that does not pay taxes on business income. Rather the members of the LLC are taxed on their share of the profits generated by the LLC. State or local governments in the United States and other countries classify LLC taxes into several categories and may impose additional fees accordingly. For example, an LLC may be classified as a corporation, a partnership, or a ‘disregarded entity’ and members may choose to have the LLC taxed as a corporation. Is an LLC a corporation?
According to local, state, and federal rules members of LLCs are required to pay income tax on their earnings as well as self-employment costs. If you are self-employed you will not be responsible for Medicare and social security taxes.
If you are a supplier of specific goods or you have employees you may be responsible for payroll taxes. The tax classification for your LLC will be determined by the type of company you have and its specific practices.
In this post, we will go through the many types of LLC taxes, what taxes you will be liable for, and how to lower your tax burden. A basic understanding of how LLC taxes work ahead of time will allow you and other members of the LLC to make more informed decisions regarding finances and taxation.
For more information check our full guide entitled ‘What LLC Means’ here.
An LLC is considered to be a partnership or sole proprietorship based on the number of members it has.
Single Owner LLCs
For tax purposes the IRS considers a single-owner LLC to be a ‘sole proprietorship’ which means that the firm is not required to pay taxes or file an income tax return.
As a single owner of an LLC, all the income (or losses) from your LLC must be disclosed on a Schedule C Form and submitted together with your Form 1040. If you have deposited money into the firm’s bank account to cover business expenses at year-end, you will be required to pay tax on that amount of income.
The IRS considers an LLC owned by multiple members a ‘partnership’. Similar to single-owner LLCs, co-owned LLCs don’t pay taxes on business profits. Instead, each member of the LLC is obligated to pay taxes on their individual portions of the profits on their personal income tax return and attach the Schedule E Form. The distributive share of profits and losses must be defined in the LLCs operating agreement.
For more information view our guide to ‘LLC Operating Agreements’ here.
Distribution of Profits Between LLC Members
In most cases an LLC member’s distribution is determined by the individual proportionate interest they hold in the LLC and typically defined in the Operating Agreement of the LLC.
LLCs are not taxed at a corporate level as is the case with corporations but profits and losses are proportionately divided among its members. The percentage of each member’s ownership determines the amount they will earn out of each profit and loss ‘pool’. For example, if one member of an LLC owns 55% and another owns 45%, the one with 55% ownership will receive 55% of the profits generated by the sale of goods while the one with 45% ownership will be entitled to the remaining portion of 45% of the profits.
Members of an LLC who are also employed by the LLC must also receive ‘reasonable compensation for their work. This is typically done with a simple written agreement setting out the amount of money each member will receive and what it will go towards such as salaries or dividends.
All Taxes are Collected on the Entire Distribution of the LLC
Although the distributive shares of the LLC will be divided up, each year the IRS will consider each LLC member to have received their full distribution share for that year. This means that each member of the LLC will be required to pay tax on their full distributive share even if only a portion or none of the money has actually been distributed by the company to its members.
The impact of this regulation by the IRS means that even though members are required to retain their earnings in the LLC in order to expand operations or acquire goods, each member is liable for income tax on the entire portion of their share.
Filing of IRS Form 1065
Although a Multiple-owned LLC is not required to pay taxes, it nevertheless must submit a Form 1065 to the IRS. Similar to the form used by partnerships, Form 1065 serves as an informative return that enables the IRS to verify that each member of the LLC has reported their earnings correctly.
The LLC must provide its members with a Schedule K-1 Form that breaks down the individual share of the profits and losses received from the LLC. Each member is required to report this information on Form 1040 and submit it together with the Schedule E attachment.
Consider Choosing the Corporate Tax Option Before Making a Decision
If you are planning on keeping a lot of money in the LLC’s bank account, it may benefit you to choose to pay corporate tax. Any LLC may opt to be taxed as a corporation by completing an IRS 8832 Form and checking the ‘Corporate Tax Treatment’ option on the form.
All ‘C’ Corporations are taxed at a flat rate of 21% on all earnings from the beginning of 2018. This is a lower rate than the top 3 individual income tax rates that would otherwise be based on the earnings of each LLC member.
You can save money on overall taxes if your business is operated as a limited liability company by choosing to be taxed as a ‘C’ Corporation. However, these savings may be difficult to bring about because income distributed to owners of a ‘C’ Corporation will be subject to double taxation. First shareholders must pay the 21% corporate tax and then they are also liable for personal income tax.
The abovementioned features can make a significant difference. For example, retained earnings will not be taxed twice, and paying corporate tax may allow LLCs to provide their members and employees with fringe benefits such as tax-advantaged stock ownership plans and other options to avoid double taxation.
Estimating and Paying Income Taxes
A member of an LLC is not considered to be an employee and is therefore not subject to tax withholding when they get paid. Each member should set enough money aside to pay taxes on their share of the LLC profits when due. Each member should estimate their yearly tax obligation and must make quarterly payments in April, June, September, and January to the IRS and appropriate state tax agency (if there is a state income tax to be paid).
Because the IRS does not consider LLC members to be employees no Medicare or Social Security will be deducted from their payments. Each individual member must pay ‘self-employment taxes’ directly to the IRS when being paid by a company owner instead of into a government fund.
The current requirement is that any owner who actively engages in or assists in the management of an LLC must pay ‘self-employment taxes’ on their distributive portion of the profits (‘proper share of profits’). Non-active members, however, such as owners who simply invest their cash but provide no services or make any management decisions in the LLC may be exempted from tax payments.
The rules on self-employment taxation in this sector are quite complex but basically, if you are active in the operation of your LLC you will be liable for the payment of self-employment tax on all the revenue allocated to you by the company.
The amount of tax due is reported by each self-employed individual on the Schedule SE Form that must be submitted with their tax returns. As self-employment tax contributions by regular employees are matched by employers, sole proprietors and partners of LLCs will pay twice as much under self-employment tax. (LLC owners are, however, allowed to deduct half of the overall amount of their taxable income which may save them a few tax dollars.
The tax for a self-employed company owner is a flat rate of 15.3% of their net income up to an annual limit. Thereafter it is 2.9% of earnings that exceed the threshold amount.
For updated information on yearly net income threshold amounts visit the IRS website.
Deductions and Expenses
As you probably already know, you won’t be required to pay tax on the bulk of your company expenditure. You are allowed to deduct legitimate business costs from the company’s earnings which could significantly lower the amount you disclose to the IRS for tax purposes. Examples of deductible expenditures may include travel costs, start-up expenses, advertising and promotion costs, and equipment purchases to name a few.
Owners of LLCs, partnerships, and sole proprietorships may also be eligible for the new income tax deduction as stated by the Tax Cuts and Jobs Act if they employ fewer than 25 people. In addition, LLC owners are allowed to deduct 20% of net income from their pass-through entities’ earnings for tax purposes.
As an example, if you are the owner of a single-member LLC with a net income of $100000 an amount of $20,000 may be deducted from your taxable income. This deduction will be limited to 50% contributed by employee payments plus 2.5% of the value of your depreciable business property if your taxable income exceeds the annual threshold.
This deduction will be limited for business owners engaged in the services industry and will be phased out if taxpayers are involved in several types of different industries. The deduction will also be prohibited for use by regular ‘C’ Corporations or for LLCs that opt to be taxed as ‘C’ Corporations.
See the difference between a nonprofit vs LLC here.
State Taxes and Fees
In every state, the profits of an LLC are taxed the same way as normal IRS-formed entities except that LLC members are liable to pay tax on their personal earnings while the LLC itself does not pay tax.
Additional Taxes in Some States
In some states, LLCs are taxed on the amount of income generated by the LLC in addition to income taxes paid by the owners.
For example in California LLCs that generate more than $250,000 per year are charged taxes that range from around $9,000 to $11,000 per year.
Annual Fees Charged in Some States
Some states charge an LLC fee referred to as a ‘ renewal fee’, an ‘annual registration fee’, or a ‘franchise tax’ that is not based on income from the LLC.
Before starting your LLC you should check whether a separate LLC tax or fee is charged by your state. You can check your state’s Department of Corporations, Secretary of State, or Department of Revenue Services website for more information.
As can be seen from the above, the owner of an LLC may be liable for a variety of LLC taxes. With so many duties to consider, it is essential to be organized to ensure that all the proper forms are filed and that your taxes are paid on time. If you run out of time you can apply for an extension to avoid paying any fines. Once your taxes are done, you can focus on the things that matter most – like running your business, making your customers happy, and earning great profits.
If you need to refresh your memory on all the information contained in this post you can bookmark this page or download it to your mobile phone to use as a quick reference whenever needed. As an entrepreneur, now is the time to get your taxes sorted so that you can concentrate on successfully managing your business.