You’ve decided to set up a limited liability company and completed your LLC operating agreement, but now you’re probably wondering: how are LLCs taxed?
In most cases, the IRS considers LLCs “pass-through” entities for federal tax classification purposes. This means the company’s profits and losses “pass-through” the business to the owners (members), who report these details on their personal tax returns.
While the LLC itself is not liable for federal income taxes, some states do impose a tax on them. For example, all LLCs in California must pay an annual tax of $800 regardless of whether they conducted any business that year.
LLC tax benefits vary depending on the number of members and whether you choose to be taxed as a corporation. Here’s what you need to know about LLC taxes before forming an LLC of your own:
Tax Classification for LLCs
Depending on the number of members, the IRS treats an LLC either as a sole proprietorship or a partnership. However, if you need to retain a significant portion of profits in your LLC on a regular basis (“retained earnings”), you may benefit from being taxed as a corporation.
A professional limited liability company (PLLC) offers the same tax classifications as an LLC.
Being classified as a pass-through entity is one of the many advantages of a partnership, LLC, sole proprietorship, and S Corp.
Single-Member LLC Tax Rate
Single-member LLCs are categorized by the IRS as sole proprietorships and disregarded entities for tax purposes. This means they are not liable for taxation and do not file tax returns.
Instead, the owner reports all LLC profits and losses on Schedule C. Any net income is included in Line 12 of your personal tax return — usually Form 1040.
Multi-Member LLC Tax Rate
The IRS usually treats LLCs with more than one member as partnerships for tax purposes. LLC partnership taxes are paid by the partners in accordance with their share of the business under the partnership agreement.
For example, if you own 45% of the business, and your partner owns 55%, you will pay 45% of the tax owed by the LLC, and your partner will pay the remaining 55%.
You pay tax on your entire distributive share of earnings, even if the LLC doesn’t distribute any profits to its members. The LLC files a Form 1065 with the IRS, which the IRS uses to determine whether all LLC members are reporting their income correctly.
The LLC must assign a Schedule K-1 to every member, outlining each member’s portion of the LLC’s profits and losses. Each LLC member then reports this information on their own personal Form 1040, with Schedule E attached.
LLCs can either be managed exclusively by the members (member-managed LLC), by one or more members, or by a third-party (manager-managed LLC). Read more about whether you should choose member-managed or manager-managed.
S Corp Tax Rate
If LLC members agree that a substantial portion of profits should be left within the business, you could benefit from corporate taxation, either as a C Corporation or an S Corporation.
C Corporation profits are taxed and reported on the corporation tax return (Form 1120), and any after-tax profits distributed as dividends are taxed again and submitted on shareholders’ personal tax returns.
Electing S Corp status for your LLC avoids this double taxation.
An LLC taxed as an S Corp is treated similarly to a sole proprietorship or a partnership. Any profits or losses are passed through the S Corp to the shareholders, who report them on their personal tax returns.
This can reduce taxes for high-income individuals. You can decide which LLC structure you want to use by filing IRS Form 8832 – Entity Classification Election.
The LLC is then liable for income tax, including state income tax, according to its new tax status. The LLC members’ taxation will also change.
C Corp Tax Rate
Since 2018, all C corporations have been taxed at a flat 21% rate on all their profits. Given that the top three individual income tax rates range from 32% to 37%, you can see the tax benefits for LLC owners on higher incomes choosing to be taxed as a C corporation.
Nonetheless, because after-tax earnings distributed to shareholders as dividends are also taxed at a capital gains rate of up to 23.8%, the savings can be minimal.
However, retained earnings are not liable to double taxation. Furthermore, corporate taxation gives LLC owners and employees various fringe benefits, stock options, and stock ownership plans that are also free from double taxation.
How to File Taxes for LLC
Depending on whether your LLC has one or more members, or you elect to be taxed as a corporation, you will require different LLC tax forms.
If yours is a single-member LLC, simply include all of the LLC’s income and expenses on the Schedule C attachment of your IRS Form 1040.
The net gain or loss you submit on Schedule C is reported as “other income” on page 1 of the 1040. You are then solely liable for all of the LLC’s tax payments.
For LLCs designated as partnerships, you will need to file an annual Form 1065. You must also file a Schedule K-1 for each member or partner, apportioning income and expenses according to your agreed assignment of partnership interest.
Each member then submits this amount on a personal income tax return. All members are liable for federal taxes on the LLC’s income.
How Are Income Taxes Calculated for LLCs?
The income tax rate for a single-member LLC depends on that owner’s total income. LLCs will often pay taxes at a lower rate than corporations.
For example, corporations pay 34% tax on $75,000 of taxable income, whereas the personal tax rate for the same amount is 25%.
If an LLC elects to be taxed as an S Corp or C Corp, it may reduce employment taxes such as Medicare or Social Security taxes, but it may also result in double taxation due to taxes on both corporate net income and dividend income.
It’s important to thoroughly research the various tax classifications for an LLC in order to minimize your overall payments and make your business as profitable as possible. You will also want to consider how much it will cost you to set up an LLC.
LLC Deductions and Expenses
As a small business, an LLC is allowed to deduct various business expenses when filing taxes. Business expenses are defined by the IRS as “the cost of carrying on a trade or business.”
Deductible business expenses must be considered ordinary and necessary costs of doing business in your particular field.
For example, the deductible expenses of a coffee shop business would include:
- The cost of coffee beans and soy or milk products
- The labor costs of your baristas
- The rent for your shop
Properly deducting your business expenses will help you reduce the taxable income of your LLC, and ensures more money stays in your company.
Furthermore, the Tax Cuts and Jobs Act of 2017 brought with it significant changes to deductions and expenses for small business taxpayers. It passed a new deduction standard for LLCs equal to 20% of the owner’s qualified business income (QBI).
QBI is essentially the net income, gain, deduction, and loss from doing business. The QBI threshold is $315,000 for a joint tax return and $157,500 for all others.
For more information, refer to the following tax guide for LLCs who elect to use Schedule C for tax filing purposes.
