Limited liability companies are business entities in the United States. They are similar to that of a Corporation or a Partnership, but they have unique tax characteristics. Forming an LLC provides limited liability protection for its owners (who are called "members"). These members are always taxed at their personal tax rates.
How a limited liability company pays income tax will depend on various factors such as how many members the LLC has, or if the LLC elects to be treated as a different business form for tax purposes.
Starting an LLC can be done easily by registering in your state, and filing Articles of Organization. Then filing fees must be paid. Despite this, the Internal Revenue Service (IRS) doesn't recognize LLCs for tax purposes. Therefore, how is an LLC taxed?
Automatically a Limited Liability Company (LLC) is not a separate tax entity like a corporation. Rather, LLCs are what the IRS calls a “pass-through entity.” This is comparable to a partnership or sole proprietorship.
When it comes to single-member LLCs, the IRS always treats them as disregarded entities. It is important to understand this, because it dictates that the LLC is one in the same as the owner when it comes to taxation. Disregarded entities are taxed in the same way as sole proprietorships. This means that all information regarding the income and expenses of the LLC are calculated on a Schedule C. The net income from a Schedule C is then brought over to your personal tax return.
An LLC that has more than one member will usually pay income tax as though it is a partnership. Although the LLC will not pay taxes directly to the IRS, instead each individual member will pay tax based on each individual share of ownership in the partnership.
LLCs can choose to elect taxation as either a C-corporation or S-corporation for tax purposes. The voting procedure and consent required to make this change must then be reflected in the LLC operating agreement.
Your LLC can choose to be taxed as a C-corporation by filing Form 8832 with the IRS. If you choose to make this change, your LLC will be required to pay a 21% federal corporate tax rate. You will also be required to pay state and local corporate taxes as well.
If you choose to elect S-corporation tax status, then you can file Form 2553 with the IRS. S-corps are taxed as a pass-through entity, which is similar to an LLC. Despite this, there are differences in how salary and distributions from the business are taxed. To file taxes for an S-corp, you must submit Form 1120S.
Electing corporate tax status won’t affect your LLC in terms of legalities. Your business will still continue to operate as an LLC. You should consult with a tax professional if you think you may benefit from corporate tax status. This income will be taxed differently, and oftentimes corporations are eligible for more deductions and credits.
When your business spends, you can deduct (also known as "write off") your legitimate business expenses from your business income. This can greatly lower the profits that you are required to report to the IRS. Deductible expenses include:
Typically, the state taxes LLC profits the same way the IRS does. This means that the LLC owners pay taxes to the state on their personal returns. Despite this, the LLC itself does not pay a state tax, it passes through the owner’s personal tax returns.
In some states, there are state income taxes. For example, in the state of California, there is an added tax for LLCs that make more than $250,000 per year. This tax ranges from about $900 to $11,000. There are annual fees in some states. These are called franchise taxes. This fee is around $100 for most states but, as an extreme example, California charges an $800 minimum fee.
LLC members are not employees, which means contributions to Social Security and Medicare systems are not withheld from paychecks. Instead, as an LLC owner, you will be required to pay self-employment taxes. Any owner who works in or helps manage the business must pay this tax on their share of the profits. If an owner is not active in the LLC, then they may be exempt from paying these taxes.
LLC owners pay twice as much self-employment tax as regular employees because this is typically matched by employers. Despite this, LLC owners are able to deduct half of the total amount from their taxable income. The self-employment tax rate for business owners is 15.3% of all net income.
Most states tax LLCs in the same way that the IRS does, through personal tax returns. LLCs do not pay state taxes on their own, and it is always passed through to the members. There are a few states that charge LLC taxes based on income, and this is in addition to federal income taxes. Overall though, it is important to understand that LLC owners are responsible for paying their own taxes and explaining deductions on taxable income to the IRS.