LLC Taxation: How Does It Work?
Looking for the right business structure for your new venture?
Creating an LLC can be the solution if you want to keep your personal assets protected as a business owner.
While there are some limitations to this protection, it is still one of the biggest advantages of LLC. As a matter of fact, it is the sole reason why many businesses prefer LLC over Sole Proprietorship and Partnership.
Apart from this protection, another important reason for selecting LLC is the taxes. A lot of new businesses prefer LLC over Corporation mostly due to this taxation benefit.
If you’re all set to create an LLC, understanding how LLC taxation works is important too.
So, how do LLCs pay taxes? Let us have a detailed look.
How Does IRS Treat LLC Taxation?
An LLC is not a taxing entity as per the IRS. If the LLC has multiple owners (known as members), IRS taxes it as a Corporation or Partnership. Its taxation will be similar to Sole Proprietorship if there is only a single owner or member.
IRS treats single owner LLCs as disregarded entities. A disregarded entity is separate from the owner for all the purposes except taxation. This means that their taxation is done through the personal tax returns of the owner.
In simple words, the taxation of LLCs depends on the number of owners or members an LLC.
How Do Single Member LLCs Pay Income Tax?
The taxation of single-member LLC is done just like a Sole Proprietorship. LLC itself will not pay taxes or file returns. The single owner of the LLC has to report all the profits or losses on Schedule C. The same is then submitted with the form 1040 or other tax return form.
A lot of LLCs also leave some profits in their bank account at the end of the year. This is usually for covering expenses, business expansion, etc. Income tax is payable on this profit as well.
How Do Multiple-Member LLCs Pay Income Tax?
When it comes to LLCs with multiple owners or members, their taxation is generally done just like a Partnership. Individual partners need to pay taxes as per their ownership share in a Partnership. The Partnership entity itself does not directly pay taxes to the IRS. The same rule applies to LLCs that are Partnerships.
Form 1065 is used by a Partnership as well as an LLC treated as a Partnership for tax purposes to file an information return. This is followed by preparing Schedule K-1 for every partner. It shows the total profit or loss share of every partner during the financial year.
Then this K-1 filing is done with that of the individual return of every partner. The Form 1040 of individual partners show the profit or loss of their partnership. Each partner will also attach Schedule E with the return form.
For instance, if there is an LLC with four owners who equally share the business.
Let us assume that the LLC made $100,000 in profits in the financial year. So, the profit share of every owner will be $25,000.
This $25,000 is the amount on which each owner will have to pay income tax of their LLC.
What About LLCs Classified as S Corporation or Corporation?
LLCs are also allowed to be classified as S Corporation or Corporation for tax purposes. The LLC generally selects these options if it enables them to reduce the tax burden.
As an S Corporation or Corporation, the LLC will pay income tax as per the new 2018 tax status. The new tax designation changes the way how the individual members of the LLC pay taxes.
However, the LLC continues to function as an LLC as per the company’s operating agreement.
LLCs Paying Estimated Taxes
All the owners or members of an LLC are considered to be self-employed. As a result, they are not subject to any tax withholding. This means that the members have to pay self-employment and estimated taxes to their state tax office and IRS. This needs to be done on a quarterly basis.
However, multi-member Partnerships can also have inactive members. These are the members who have invested money in the business but do not participate in the everyday functioning of the company.
They do not offer any kind of service to the business nor take any management decisions. Such inactive members can be exempt from paying self-employment tax.
LLCs and State Income Tax
LLC classification for state income tax purposes is different in every state. Most states use the IRS classification but have made changes in the applicable tax rate.
For instance, LLCs in Florida that are classified as Partnerships have to pay Partnership taxes. In case of a Corporation, Corporate taxes are applicable. LLCs which are Sole Proprietors are not required to pay a separate business tax. It uses federal taxable income and has made changes to it.
On the other hand, in California, LLCs that are disregarded entity or Partnership pay $800 as state income tax. They have to file a particular return. But the LLCs that are classified as Corporations file a different return and pay appropriate taxes.
Taxation of LLCs in Case of Losses
LLC taxation is mostly beneficial if the LLC is making profits. But the same is not true in case of losses. As your personal liability in your company is limited, you’re not allowed to deduct all the losses. Some of the states charge additional fees and taxes on LLCs.
You can check how your state treats LLC tax implications to know more. In most cases, this additional fee is a flat annual tax.
For instance, in California, there are two different fees for state-registered LLCs that make $250,000+. Keep a close eye on the tax developments on the state as well as federal level to know all the key changes.
While this might look like a lot of information to digest at once, you will surely get better with time. Try to know at least the basics of how LLCs pay taxes if you are new to owning a business and are planning to create an LLC.
This will make it easier for you to understand tax discussions with your legal advisors.
Try to keep learning about tax laws for LLCs as this can protect you from legal troubles. Moreover, with a bit of experience, it can also help you save a lot of money.