A Limited Liability Company (LLC) is not a separate tax entity like a corporation; instead, it is what the IRS calls a “pass-through entity,” like a partnership or sole proprietorship.
All of the profits and losses of the LLC “pass through” the business to the LLC owners (called members), who report this information on their personal tax returns. The LLC itself does not pay federal income taxes, but some states do charge the LLC itself a tax.
The IRS treats your LLC like a sole proprietorship or a partnership, depending on the number of members in your LLC. If you’ve already done business as a sole proprietorship or partnership, you’re ahead of the game because you know many of the rules already. If not, here are the basics:
The IRS treats one-member LLCs as sole proprietorships for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS.
As the sole owner of your LLC, you must report all profits (or losses) of the LLC 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—for instance, to cover future expenses or expand the business—you must pay taxes on that money.
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 lawful 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 his 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 in the business, it’s called a “special allocation,” and you must carefully 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 actually distributes the money to him/her. The practical significance of this IRS rule is that even if LLC members need to leave profits in the LLC—for instance, to buy inventory or expand the business—each LLC member is liable for income tax on her/his rightful share of that money.
Even though a co-owned LLC itself does not pay income taxes, it must file Form 1065 with the IRS. This form, the same one that a partnership files, is an informational return that the IRS reviews to make sure the LLC members are reporting their income correctly. 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. In turn, each LLC member reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.
LLCs can elect corporate taxation
If your LLC will regularly need to retain a significant amount of profits in the company, you (and your co-owners, if you have any) may be able to save money by electing to have your LLC taxed as a corporation. 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 not considered employees of the LLC, but rather self-employed business owners, they are not subject to tax withholding. Instead, each LLC member is responsible for setting aside enough money to pay taxes on his/her share of the profits. The members must estimate the amount of tax they’ll owe for the year and make payments to the IRS (and usually to the appropriate state tax agency) each quarter—in April, June, September and January.
Because, again, LLC members are not employees but self-employed business owners, contributions to the Social Security and Medicare systems (collectively called the “self-employment” tax) are not withheld from their paychecks. Instead, most LLC owners are required to pay the self-employment tax directly to the IRS.
The current rule is that any owner who works in or helps manage the business must pay this tax on their distributive share—his or her rightful share of profits. However, owners who are not active in the LLC—that is, those who have merely invested money but don’t provide services or make management decisions for the LLC—may be exempt from paying self-employment taxes on their share of profits. The regulations in this area are a bit complicated, but if you actively manage or work in your LLC, you can expect to pay the self-employment tax on all LLC profits allocated to you.
Each owner who is subject to the self-employment tax reports it on Schedule SE, which s/he submits annually with his/her 1040 tax return. LLC owners pay twice as much self-employment tax as regular employees, since regular employees’ contributions to the self-employment tax are matched by their employers. The self-employment tax rate for 2002 for business owners is 15.3% of the first $84,900 of income and 2.9% of everything over $84,900. You’ll need to research the current year’s rate.
Expenses and deductions
As you no doubt already know, you don’t have to pay taxes—income taxes or self-employment taxes—on money that your business spends in pursuit of profit. You can deduct (“write off”) your legitimate business expenses from your business income, which can greatly lower the profits you must report to the IRS. Deductible expenses include start-up costs, automobile, travel and entertainment expenses and advertising and promotion costs.
State taxes and fees
Most states tax LLC profits the same way the IRS does: The LLC owners pay taxes to the state on their personal returns; the LLC itself does not pay a state tax. A few states, however, do charge the LLC a tax based on the amount of income the LLC makes, in addition to the income tax its owners pay. For instance, California levies a tax on LLCs that make over $250,000 per year; the tax ranges from about $1,000 to $9,000.
In addition, some states (including California, Delaware, Illinois, Massachusetts, New Hampshire, Pennsylvania and Wyoming) impose an annual fee on LLCs, called a ” franchise tax,” an “annual registration fee” or a “renewal fee.” In most states, the fee is about $100, but California exacts a hefty $800 fee per year from LLCs, and Illinois, Massachusetts and Pennsylvania charge $300, $500 and $330, respectively. Before forming an LLC, find out if your state charges a separate LLC-level tax 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 a substantial amount of profits in your LLC (called “retained earnings”), you might benefit from electing corporate taxation. Any LLC can be treated like a corporation for tax purposes by filing IRS Form 8832 and checking the corporate tax treatment box on the form.
After making this election, profits kept in the LLC are taxed at the separate income tax rates that apply to corporations; the owners don’t pay personal income taxes on profits left in the company. (Unlike an LLC, a corporation pays its own taxes on all corporate profits left in the business.) Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to most LLC owners, this can save you and your co-owners money in overall taxes.
For example, if your retail outfit needs to stock up on expensive inventory at the beginning of each year, you might decide to leave $50,000 in your business at year’s end. With the regular pass-through taxation of an LLC, these retained profits would likely be taxed at your individual tax rate, which is probably over 27%. But with corporate taxation, that $50,000 is taxed at the lower 15% corporate rate.
Once you elect corporate taxation, however, you can’t switch back to pass-through taxation for five years, and if you do switch back, there could be negative tax consequences. In other words, you should treat the decision to elect corporate taxation as seriously as you would the decision to convert your LLC to a corporation.