A limited liability company (LLC) is not a separate tax entity like a corporation; instead, it is what the IRS calls a “pass-through entity,” like a partnership or sole proprietorship. All of the profits and losses of the LLC “pass-through” the business to the LLC owners (called members), who report this information on their personal tax returns. The LLC itself does not pay federal income taxes, although some states impose an annual tax on LLCs.
If you operate your business using a limited liability company (LLC), then you have more flexibility in choosing how the IRS taxes your business earnings. Your choice will directly influence the tax filing rules you are subject to. There is no set of tax rules that specifically apply to LLCs; the IRS allows the LLC to use partnership, corporate or sole proprietor tax rules.
Type Of Taxes They Pay
The type of taxes you pay can determine if there is a tax refund for your business.
Here are some situations where a business might receive a refund:
- Income Taxes: As discussed above, the only business entity that would receive a refund of income tax is a C corporation. Owners, partners or shareholders would receive a refund on their personal return based on their total income.
- Payroll Taxes: You might receive a refund, regardless of your entity type, if your business withholds and pays payroll taxes and you overpaid. Restaurants might also receive a tip credit – a tax credit that can be used to reduce the income tax owed by the employer – which could result in a refund.
- Sales or Excise Taxes: Most companies are subject to sales or excise taxes, which typically are assessed by states or municipalities. Sometimes, either an overpayment or these taxes or reassessment of the property value can result in a refund to a business.
If you’ve paid in more than your actual tax liability, you will be owed a refund. Keep in mind though how complicated business taxes can be.
If you are unsure about how your business is being taxed and whether you should be getting a refund, contact an experienced tax preparer.
IRS default designations
Immediately after you create the LLC, the IRS automatically treats your business as a partnership, but only for income tax purposes. However, if you are the sole owner of the LLC, then you must pay tax on business profits as if you were a sole proprietor. Both designations have different tax filing rules. If you prefer the tax filing rules of a corporation, then you have the option to elect corporate tax treatment by filing IRS Form 8832. Once you make this election, you cannot change the LLC designation again for five years.
Partnership filing requirements
Limited liability companies that are subject to the partnership tax rules are not responsible for actually paying the tax on business earnings, but are responsible for preparing annual partnership tax returns on IRS Form 1065. This return is for informational purposes only; each individual owner reports all income, deductions and credits on their own tax returns.
The LLC reports each owner’s share of these amounts on a Schedule K-1 at the end of the year. For example, if you and a friend create an LLC to run a business that earns $100,000 and has $60,000 of deductible business expenses, then each of you will receive a Schedule K-1 with $50,000 of earnings and $30,000 of deductions. Both of you must then report these figures on your personal income tax returns. Essentially, the business will increase your personal taxable income by $20,000.
Corporate filing requirements
If you decide to make a corporate tax election for the LLC, the IRS will treat your business as a separate taxpayer in the same way you are a separate taxpayer from your friend. As a result, the business is solely responsible for reporting all income and deductions on Form 1120 each year and paying the appropriate income tax by the deadline.
If the LLC fails to pay the tax or file a return, you and the other owners are not personally liable. However, a drawback to corporate treatment is that business earnings are taxed twice. The first level of tax occurs when the LLC files a corporate tax return, and the second is imposed on the owners when they receive a dividend. Each owner must report the dividend as taxable income on their personal Form 1040s and pay tax on it.
Single Member LLC filing requirements
Single-member LLCs are treated just like a sole proprietorship. The IRS disregards the LLC entity as being separate and distinct from the owner. Essentially, this means that you are personally responsible for all tax payments and filings. When you prepare your personal income tax return, you must now also complete a Schedule C attachment. Schedule C only reports the income and deductions that relate to your business activities. If you calculate a profit on Schedule C, then the amount is included with the other income your report on Form 1040.
What’s your entity type?
When you established your business, you picked a business entity: sole proprietorship, partnership, limited liability company (LLC), C corporation, S corporation are common choices, to name a few. Sole proprietorships, partnerships, LLCs and S corporations are known as “pass-through” entities because their taxes pass through their owners on their personal tax returns. Under the Tax Cuts and Jobs Act, passed in December 2017, they are able to deduct 20% of their income from federal income taxes. Under the previous tax code, owners were taxed on the entirety of their income. C-corps, on the other hand, is recognized as a separate taxpaying entity. We’ll take a look at each type below in more detail:
- Sole proprietorship: This is the easiest and least expensive way to structure a business. Sole proprietorships are not taxed separately. Most sole proprietors report their income with a Form 1040 and Schedule C.
- Partnership: This is the simplest structure when two or more people are involved in a business. Each partner contributes money, property, labour or specific skills and expects to share in the profits and losses of the business. A partnership must file an annual information return to report the income, deductions, gains, losses and such from its operations. But instead of paying income tax, it “passes through” any profits or losses to its partners. Each partner includes their share of the partnership’s income or loss on their individual tax return. The partnership files a copy of the Schedule K-1 (Form 1065) with the IRS to report your share of the partnership’s income, deductions, credits, etc.
- Limited Liability Corporation (LLC): An LLC provides personal assets such as your vehicle, home and banking accounts a level of protection in the event of a lawsuit against your business, though certain types of businesses — banks and insurance companies, for example — can’t be LLCs. For tax purposes, an LLC is considered a sole proprietorship (one member) or a partnership (multiple owners), though LLCs could elect to file taxes as C-corp, which we’ll describe later.
- S Corporation: Corporations are created when shareholders incorporate a business. Though an S-corp is a legal entity separate from its owners, profits are passed along to shareholders who must pay personal income tax on that profit. Unlike a C-corp, which we describe below, the number of shareholders for an S-corp is limited to 100.
- Corporation: Also called a C-corp, this is the most expensive business structure to form. Corporations offer the strongest protection to its owners from personal liability and require more extensive record-keeping, operational processes and reporting. The profit of a corporation is taxed to the corporation when earned and then is taxed to the shareholders when distributed as dividends (aka double taxation).
A C-corp is taxed separately from its owners. If a C-corp pays more estimated tax during the year than is due on the final return, it can get a tax refund.
Estimating and Paying Income Taxes
LLC members are considered self-employed business owners rather than employees of the LLC, so they are not subject to tax withholding. Instead, each LLC member is responsible for setting aside enough money to pay taxes on that member’s share of the profits. The members must estimate the amount of tax they’ll owe for the year and make quarterly payments to the IRS (and to the appropriate state tax agency, if there is a state income tax) — in April, June, September, and January.
LLC members are not employees, so no contributions to the Social Security and Medicare systems are withheld from their paychecks. Instead, most LLC owners are required to pay these taxes — called “self-employment taxes” when paid by a business owner — directly to the IRS.
The current rule is that any owner who works in or helps manage the business must pay this tax on his or her distributive share (rightful share of profits). However, owners who are not active in the LLC — that is, those who have merely invested money but don’t provide services or make management decisions for the LLC — may be exempt from paying self-employment taxes on their share of profits. The regulations in this area are a bit complicated, but if you actively manage or work in your LLC, you can expect to pay self-employment tax on all LLC profits allocated to you.
Each owner who is subject to the self-employment tax reports the amount due on Schedule SE, which must be submitted annually with his or her tax return. LLC owners (and sole proprietors and partners) pay twice as much self-employment tax as regular employees because their employers match regular employees’ contributions to the self-employment tax. (However, LLC owners also get to deduct half of the total amount from their taxable income, which saves a few tax dollars.) The self-employment tax rate for business owners is 15.3% of net income up to an annual threshold and then 2.9% for income above the threshold amount. Check the IRS website for annual net income threshold amounts.
For more on self-employment taxes, see Nolo’s article Paying Estimated Taxes.
Expenses and Deductions
As you no doubt already know, you don’t have to pay taxes — income taxes or self-employment taxes — on most of the money that your business spends. You can deduct (“write off”) your legitimate business expenses from your business income, which can greatly lower the profits you must report to the IRS. Deductible expenses include start-up costs, automobile and travel expenses, equipment costs, and advertising and promotion costs. For information about allowable expenses and deductions, see Nolo’s articles Small Business Tax Deductions and Top Tax Deductions For Your Small Business.
LLC owners may also be eligible for a new income tax deduction for pass-through entities established by the Tax Cuts and Jobs Act. Starting in 2018, the owner of a pass-through entity, including a single or multi-member LLC, can deduct for income tax purposes up to 20% of the net income from the entity. For example, if net income from a single-member LLC business is $100,000, the owner may deduct up to $20,000 from his or her income taxes. However, suppose taxable income exceeds an annual threshold. In that case, the deduction is limited to 50% of the amount paid to employees of the entity, or 25% of employee payments plus 2.5% of the value of depreciable business property. Additionally, the deduction is phased out for taxpayers involved in various types of service businesses. Also, this deduction may not be taken by regular C Corporations or LLCs that elect to be taxed as C corporations.
The IRS treats your LLC like a sole proprietorship or a partnership, depending on the number of members in your LLC. If you’ve already done business as a sole proprietorship or partnership, you’re ahead of the game because you know many of the rules already. If not, here are the basics:
The IRS treats one-member LLCs as sole proprietorships for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS.
As the sole owner of your LLC, you must report all profits (or losses) of the LLC on Schedule C and submit it with your 1040 tax return. Even if you leave profits in the company’s bank account at the end of the year—for instance, to cover future expenses or expand the business—you must pay taxes on that money.
The IRS treats co-owned LLCs as partnerships for tax purposes. Co-owned LLCs themselves do not pay taxes on business income; instead, the LLC owners each pay taxes on their lawful share of the profits on their personal income tax returns (with Schedule E attached). Each LLC member’s share of profits and losses called a distributive share is set out in the LLC operating agreement.
Most operating agreements provide that a member’s distributive share is in proportion to his percentage interest in the business. For instance, if Jimmy owns 60% of the LLC, and Luana owns the other 40%, Jimmy will be entitled to 60% of the LLC’s profits and losses, and Luana will be entitled to 40%. If you’d like to split up profits and losses in a way that is not proportionate to the members’ percentage interests in the business, it’s called a “special allocation,” and you must carefully follow IRS rules.
However, members’ distributive shares are divvied up, and the IRS treats each LLC member as though they receive their entire distributive share each year. This means that each LLC member must pay taxes on their distributive share whether or not the LLC distributes the money to him/her. The practical significance of this IRS rule is that even if LLC members need to leave profits in the LLC—for instance, to buy inventory or expand the business—each LLC member is liable for income tax on her/his rightful share of that money.
Even though a co-owned LLC itself does not pay income taxes, it must file Form 1065 with the IRS. This form, the same one that a partnership files, is an informational return that the IRS reviews to make sure the LLC members are reporting their income correctly. The LLC must also provide each LLC member with a “Schedule K-1,” which breaks down each member’s share of the LLC’s profits and losses. In turn, each LLC member reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.
Can corporate taxation cut your LLC tax bill?
If you regularly need to keep a substantial amount of profits in your LLC (called “retained earnings”), you might benefit from electing corporate taxation. Any LLC can be treated like a corporation for tax purposes by filing IRS Form 8832 and checking the corporate tax treatment box on the form.
After making this election, profits kept in the LLC are taxed at the separate income tax rates that apply to corporations; the owners don’t pay personal income taxes on profits left in the company. (Unlike an LLC, a corporation pays its taxes on all corporate profits left in the business.) Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to most LLC owners, this can save you and your co-owners money in overall taxes.
For example, if your retail outfit needs to stock up on expensive inventory at the beginning of each year, you might decide to leave $50,000 in your business at year’s end. With the regular pass-through taxation of an LLC, these retained profits would likely be taxed at your individual tax rate, which is probably over 27%. But with corporate taxation, that $50,000 is taxed at the lower 15% corporate rate.
Once you elect corporate taxation, however, you can’t switch back to pass-through taxation for five years, and if you do switchback, there could be negative tax consequences. In other words, you should treat the decision to elect corporate taxation as seriously as you would the decision to convert your LLC to a corporation.