Do you want to understand how a limited liability company (LLC) is taxed? An LLC is not taxed separately like a corporation. The IRS classifies it as a pass-through entity such as a sole proprietorship or a partnership.
How is an LLC taxed? All losses and profits incurred by a limited liability company are passed on to the business owners known as members. The LLC members have a responsibility to report the profits or losses on their personal tax returns.
Limited liability companies in most states are not obligated to pay federal income taxes. However, in some states, the LLC has to pay annual state taxes. To understand everything about LLC taxation, read on below:
LLC Income Taxes
How is LLC income taxed? Depending on how many members an LLC has, the IRS treats it like a partnership or a sole proprietorship. Below are the two types of LLCs and how they are taxed:
- Single-Membered LLCs
If your LLC has only one member, the IRS treats it as a sole proprietorship when it comes to taxes. For this reason, the LLC doesn’t have to file annual tax returns with the IRS and is not obligated to pay taxes.
The LLC’s sole member must report all losses or profits of the company on Schedule C. This tax information is then submitted with the 1040 tax return Form. For example, if you choose to leave a percentage of the profit in the company’s account for future use, you must report and pay income tax on this amount of money.
- Multiple-Owned LLCs
LLCs co-owned by multiple members are like partnerships when it comes to taxation. Just like single-membered LLCs, the company doesn’t pay business income tax. The members are each taxed personal income tax returns based on their share of the LLCs profits.
Each member of the LLC shares the loss and profits incurred by the business. This is also known as a distributive share and comes in the LLC operating agreement.
How Are Profits Divided Between Members?
Depending on your LLC’s operating agreement, profits and losses among members are divided differently. Each member’s distributive share is equal to their percentage interest in the company. For example, if John owns 51% of the business, Jane owns 30%, and Tim owns 19%, John will get 51% of the profits, Jane 30%, and Tim 19%.
However, some members prefer dividing the loss and profits in a way that’s not equal to the members’ percentage interest. Tt’s known as special allocation, and the IRS must approve it.
Sometimes the IRS may reject your special allocation application. This is because some business owners often use this to reduce their payable taxes by moving their income around. For a special allocation to be approved by the IRS, the LLC members must prove their substantial economic effect.
How the IRS Taxes the Members’ Distributive Share
However, the profits and losses are divided when it comes to taxation, the IRS considers each member as though they got the full distributive share at the end of the tax year. All LLC members must file and pay taxes on their full share of the profits, whether or not the LLC distributed all the money.
All LLC members are mandated to pay income tax based on their rightful share of the profit and losses even if they choose to leave a percentage of that money in the LLC for business expansion or inventory purchase.
Filing IRS Form 1065
While the IRS excludes LLCs from paying their own income taxes, Form 1065 must be filed. This is an information form that’s also filed by partnerships. The IRS uses this form to confirm that the LLC members are correctly reporting their incomes.
The company also provides a Schedule K-1 for each member to break down their share of the losses and profits. In turn, the members use this information to file their individual taxes on Form 1040 and attach the Schedule E.
When Should LLCs Elect Corporate Taxation?
If you continuously need to withhold a large percentage of your profits in the LLC for inventory, expansion, or future projects, you should consider electing corporate taxation. This means that you prefer being taxed the same way as a corporation. To do this, you must file Form 8832 with the IRS and tick on the corporate tax treatment box.
The 2020 federal taxes law states that a 21% flat tax rate is enforced on all regular ‘C’ corporations. This is a lower percentage than the individual income tax percentages that range from 32% to 37%. This means that you can save some money by electing corporate taxation.
Sometimes the LLC members might not make any savings because the C corporation owners are double taxed. Their money will be first taxed 21% corporate tax then subjected to a second individual income tax as shareholders on their annual gains and dividends. This tax ranges up to 23.8%.
One of the most significant benefits of applying for taxation as a C corporation is that retained earnings are not taxed. The LLC members and employees also benefit from stock ownership and options that are not double taxed.
How Do LLC Members Pay Income Taxes?
LLC owners are not considered as employees; the IRS considers them self-employed individuals. This means their taxes are not withheld, and they’re responsible for paying their taxes directly to the IRS.
Each member should estimate how much they will owe in taxes for that year and set aside that money. Income tax is paid every quarterly to the IRS and the right local state tax agency. Taxes are paid in January, April, June, and September.
How to form an LLC
Forming a limited liability company is not an easy process. How long the process takes depends on how fast the state government receives, approves, and files your application. Sadly, most government bodies run their operations on legacy computers and manual processes.
While creating a company may seem overwhelming, prior planning and understanding what you need before starting the filling process can come in handy. Below are essential requirements when forming an LLC:
- A unique business name
- An operating agreement
- A registered agent to act as the point of contact for all paperwork
- File an article of organization in your state
- Business permits and licenses
- A statement of information form
- Tax Forms 8832 and 1065
- A separate bank account
All states have different requirements when forming an LLC. If you’re unsure of what to do, you can contract LLC formation services or hire a business attorney for advice. They are better equipped to handle all the documents and file all the required forms.
How Is an LLC Taxed? Now You Understand
How is an LLC taxed? Now that you understand how LLCs are taxed, you will make the most financially sound decision based on your company’s state and structure.
Depending on your state, LLC taxes can be quite confusing. Ensure you consult a tax professional before changing your tax status. For more money-saving and eye-opening advice, check out our other posts.
