Here is how LLC taxes work
According to the Inland Revenue Service (IRS), LLCs don’t actually exist, meaning that an LLC does not have its own separate tax classification.
23:31 15 January 2021
The IRS requires LLC owner/s (member/s) to choose one of the existing classifications namely:
- Single-member LLC (Sole-proprietorship / disregarded entity)
- Multiple member LLC (Partnership)
The number of owners (members) within the LLC and the business operations will determine which LLC taxes will provide the best benefits. An LLC with one owner will as a default be classified as a single-member entity and will be taxed as such.
How each classification works
The LLC will have one owner (member) and is taxed as a “disregarded entity” by the IRS. The business still operates as a LLC with all its benefits, however the taxes are recorded on the owner's personal income tax return.
When an owner is also an employee of the business, self-employment tax applies. Only businesses that provide a service or sell goods will be required to pay self-employment taxes. Should the business operations be passive such as real estate investment businesses, self-employment taxes do not apply.
As the name implies, a multiple-member LLC has more than one owner (members). The IRS treats the LLC as a partnership which means that the LLC does not pay income tax to the IRS. Profits are split between the members via an operating agreement and the individual members pay tax on their individual income tax returns. A Schedule K-1 tax form is used to indicate the profit or losses of the LLC.
An LLC can also elect to be treated as a C-Corporation. The business will pay income tax on all the gross income less the operating costs. Profits are then distributed to the different shareholders who have to pay tax individually on their respective share of the dividends. This practice is also known as double-taxation.
The LLC does not have to pay income tax on its profits, but taxes are to be paid on any salaries or wages paid to employees. The C-corporation tax structure is perfect for LLCs that plan to keep the profits within the business. Only the corporation is then taxed on the profits and the owners are not responsible for paying taxes on those profits again.
Members of an S-corporation can save on taxes, however there are special rules that apply and the income of the business will have to be significant in order to benefit. Unlike a C-corporation, the members are taxed separately on their share of the profits and they are not subject to self-employment tax.
There are certain limitations for choosing the S-corporation structure so it is important to understand the structure fully. The limitations to take into consideration are:
- No more than one class of stock is permitted.
- The maximum number of stockholders permitted is 100
- Stockholders must be US citizens or residents. There are certain exceptions to this rule.
- Must not be an eligible institution such as insurance companies or financial institutions
What else do I need to know?
Selecting the tax structure can be done when filing for an EIN (Employer Identification Number). An EIN is required should the LLC wish to appoint any employees.
Regardless of the tax classification chosen, the LLC will have to file a tax return with the IRS. All owners will have to fill out an individual tax return (Form 1040) and the appropriate schedule:
- Schedule C - Used to report any profit or losses from the business.
- Schedule SE - Used for self-employment tax.
- Schedule E - Used to report any additional income for example rental properties.
In the case of a multiple-member LLC or special entities, more paperwork will have to be filed. The following forms will also have to be filled out and submitted in addition to Form 1040:
- Form 1065 - Used to report the multiple-member LLCs profits or losses.
- Schedule K-1 - Used to report the owners individual shares of the profits.
How do I choose?
Choosing the appropriate tax classification will depend on the number of members within the LLC and the business operations. As the business evolves and grows with time, the tax structure might also change. A qualified tax practitioner can assist business owners in making the best decisions to get the most tax savings.