One of the reasons why entrepreneurs or new business owners go for LLC formation is the flexibility they get in terms of taxation.
LLCs are not taxed as a separate business entity, the way corporations are taxed. An LLC is a ‘flow-through’ or a ‘pass-through’ business entity, a mechanism where profits or losses of a business setup are passed through to its owners (referred to as members), and they pay taxes in the form of personal income instead of the organization being taxed at a corporate tax rate.
However, there are some aspects about the way LLCs are taxed and we have covered those key aspects in this guide.
How is an LLC Treated by the IRS?
The Internal Revenue Service (IRS) will treat your LLC either as a sole proprietorship or a partnership – depends on your LLC’s total number of members.
If you are the sole owner of your company or the only member of your LLC, it is referred to as a single-member LLC. The IRS will treat your business entity as a sole proprietorship for all tax-related matters.
Sole proprietorship entities neither have to pay taxes nor have to file tax returns. Instead, being the sole owner or member of the LLC, you will be required to submit your LLC’s profits or losses using the 1040 Schedule C tax return form.
If there are more than one members in your LLC, it will be called a multi-member LLC and the IRS treats such entities as partnerships for all tax-related matters.
A multi-member LLC will not be taxed itself, instead the members will be taxed according to their share of profits (called a distributive share) that is mentioned in the operating agreement. Usually, this distributive share is in accordance with a member’s percentage interest in the company. For instance, if Member X owns 30% of the company and Member Y owns the rest of the 70%, then Member X will be lawfully entitled to 30% of the company’s profits or losses and Member Y will be entitled to 70%.
Additional IRS Guidelines for Taxation
If there is a different proportion in which you want to split the company’s profits or losses, you can do that too. It is referred to as a ‘special allocation’ and you will have to follow the guidelines provided by IRS in order to do that.
Moreover, whether the members receive their entire distributive shares on a yearly basis or not, the IRS will consider as if they do and hence, members will be taxed accordingly. This is because at times members might not withdraw or receive their distributive share in order to expand the business or re-invest in the LLC by buying inventory. In such cases, the members are still taxed according to their share.
In order to maintain transparency, LLC members are required to submit Form 1065 with the IRS. This is an informational form through which the IRS ensures that members’ incomes are being reported correctly.
Estimation of Taxes by the Members
Since the members of an LLC are treated as self-employed business owners rather than employees of an LLC, they aren’t subjected to any form of withholding tax. However, each member is required to estimate and set aside money to be paid as a tax on his or her distributive share.
These payments need to be made to the IRS in addition to the relevant tax agency of the state on a quarterly basis.
Self-employment Tax to be Directly Paid to the IRS
Since the members of an LLC are not treated as the organization’s employees, self-employment taxes are not deducted from their paychecks – instead, the members have to pay self-employment taxes to the IRS directly.
These taxes are reported using Schedule SE that a member submits along with the annual 1040 tax return form.
Get Your LLC Taxed like a Corporation
An LLC does have the option to be taxed like a corporation. You can go for this option if your business nature requires your members to retain their profits in the LLC on a regular basis.
Save Money by Paying Less in Corporate Taxes
One of the major benefits of electing corporate taxation for your LLC is that you can save a good amount of money. This is because once you go for this option, the profits that are retained in your LLC will be taxed at separate income tax rates (members’ profits left in the business will not be taxed according to personal income tax rate).
Since a corporation is taxed on all corporate profits that are retained in the company, and because the corporate income tax for the initial $75,000 of taxable income is quite low as compared to individual income tax rate, you might end up saving a lot of taxes.
No Going Back for Five Years
Once you elect for corporate taxation for your LLC, you will not be able to switch back to flow-through taxation for the next five years. Make sure you do enough research before you take this all-important decision for your LLC.
Do LLCs Have to Pay State Taxes?
Usually, an LLC’s members will pay taxes to the relevant state according to their personal returns instead of the LLC itself being subject to state taxes. However, some states might charge an additional tax that is based on the LLC’s overall income. For instance, the state of California charges somewhere between $1,000 to $9,000 for LLCs that make $250,000 or more per year.
Moreover, you might come across terms such as a ‘franchise tax’ or an ‘annual fee’ that is charged by some states including California, Illinois, New Hampshire, Wyoming, etc. Usually, this fee is around $100, but the state of California charges $800 as an annual fee.
You can check the ongoing state-level taxes or fees by visiting the relevant state’s tax/revenue website (usually a separate section on the official secretary of state website).