How LLC Members Are Taxed
LLC owners report business income and losses on their personal tax returns.
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.
The IRS treats your LLC like a sole proprietorship or a partnership, depending on the number of members in your LLC.
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 income tax on that money.
The IRS treats co-owned LLCs as partnerships for tax purposes. Like one-member LLCs, co-owned LLCs do not pay taxes on business income; instead, the LLC owners each pay taxes on their 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, should be set out in the LLC operating agreement. For information on operating agreements, see Nolo’s article The LLC Operating Agreement.
Dividing up the profits between members. Most operating agreements provide that a member’s distributive share is in proportion to his or her 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. (For more information on special allocations, including the IRS rules you’ll have to follow if you wish to make them, see Nolo’s article Making Special Allocations.)
Taxes assessed on entire distributive share. However members’ distributive shares are divvied up, the IRS treats each LLC member as though the member receives his or her entire distributive share each year. This means that each LLC member must pay taxes on his or her whole distributive share, whether or not the LLC actually distributes all (or any of) the money to the members. 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 his or her rightful share of that money.
File Form 1065 with the IRS. Even though a co-owned LLC does not pay its own 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 that 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.
Consider Electing Corporate Taxation
If you will 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 choose to be treated like a corporation for tax purposes by filing IRS Form 8832, Entity Classification Election, and checking the corporate tax treatment box on the form.
Starting in 2018, all regular “C” corporations are taxed at a flat 21% rate on all their profits. This rate is lower than the top three individual income tax rates, ranging from 32% to 37%, which would otherwise apply to LLC owners at various income levels. Thus, LLC owners can save money on their overall taxes by choosing to be taxed as a C corporation. However, these potential savings can prove elusive because money distributed from a C corporation to its owners is subject to double taxation—first the 21% corporate tax must be paid and then the shareholders must pay individual income tax on their dividends at capital gains rates, which range up to 23.8%. However, retained earnings are not subject to double taxation. In addition, electing corporate taxation can allow an LLC to offer owners and employees various tax-advantaged fringe benefits, stock options, and stock ownership plans, none of which are subject to double taxation.
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 regular employees’ contributions to the self-employment tax are matched by their employers. (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.
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.
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, if taxable income exceeds an annual threshold, 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.
State Taxes and Fees
Most states tax LLC profits the same way the IRS does: The LLC owners pay taxes to the state on their personal returns, while the LLC itself does not pay a state tax.
Additional taxes in some states. A few states, however, do charge the LLC a tax based on the amount of income the LLC makes, in addition to the income tax its owners pay. For instance, California levies a tax on LLCs that make more than $250,000 per year; the tax ranges from about $900 to $11,000.
Annual fees in some states. In addition, some states impose an annual LLC fee that is not income-related. This may be called a “franchise tax,” an “annual registration fee” or a “renewal fee.” In most states, the fee is about $100, but California exacts a hefty $800 “minimum franchise tax” per year from LLCs.