“LLC” is short for limited liability company. The LLC is the most popular business form for small businesses.
Why are LLCs so popular? Two main reasons:
- LLCs provide business owners with limited liability from debts and lawsuits , and
- LLCs owners don’t have to jump through all the legal hoops corporate shareholders must deal with to preserve limited liability.
There is yet another advantage afforded by LLCs: They provide great flexibility when it comes to taxation.
All LLCs come with a default form of taxation. But you have the option of choosing out of the default mode.
Default tax treatments for LLCs
When you first form an LLC, it is automatically taxed as a sole proprietorship or partnership. Which default tax treatment applies depends on whether the LLC has a single member (owner) or multiple members.
Single-member LLCs
Many LLCs have only one member (owner). Sole proprietor taxation is the default federal tax treatment for single-member LLCs.
When taxed as a sole proprietor, you and your business are the same for tax purposes. Your LLC doesn’t pay taxes or file federal tax returns. Instead, you must report the income you earn or losses you incur from your LLC on your personal tax return (IRS Form 1040).
If you earn a profit, the money gets added to any other income you have—for example, interest income or your spouse’s income if you’re married and file a joint tax return—and that total gets taxed at your personal income tax rates.
Although you pay taxes on your total income regardless of its source, the IRS still wants to know about the profitability of your LLC business.
To show whether you have a profit or loss from your LLC, you must file IRS Schedule C, Profit or Loss From Business, with your personal tax return. On this form, you list all your business income and deductible expenses.
You also file IRS Form SE to show the Social Security and Medicare tax you must pay on your net self-employment income.
Multi-member LLCs
Partnership taxation is the default tax treatment for LLCs with more than one member.
With partnership tax treatment, the LLC is a “pass-through entity” for tax purposes. This means that the LLC ordinarily pays no taxes itself. Instead, the profits, losses, deductions, and tax credits of the LLC business get passed through the company to the owner’s individual tax returns.
If the business has a profit, the owners pay income tax on their ownership share on their individual returns at their income tax rates. If the business incurs a loss, it is likewise shared among the owners who may deduct it from other income on their returns, subject to certain limitations.
Unlike a sole proprietorship, a partnership is separate from the partners when computing income and deductions. Thus a multi-member LLC files its tax return on IRS Form 1065, U.S. Return of Partnership Income.
Form 1065 is not used to pay taxes; instead, it is an information return that informs the IRS of the LLC’s income, deductions, profits, losses, and tax credits for the year.
Form 1065 also includes a component called Schedule K-1, in which the LLC lists each member’s share of the items listed on Form 1065. Each LLC member must get a separate Schedule K-1.
Each LLC member reports on his or her tax return (Form 1040) the member’s share of the LLC’s net profit or loss, as shown on Schedule K-1. To do this, you file IRS Schedule E, Supplemental Income and Loss with your personal tax return.
Corporate taxation for LLCs
The vast majority of LLCs stick with default taxation. That is, they get taxed like sole proprietorships or partnerships.
However, you can choose to have your LLC taxed like a corporation. This option is easily accomplished by filing a document called an election with the IRS. You can submit this form at any time.
When it comes to taxes, there are two types of corporations:
- C corporations, sometimes called regular corporations, and
- S corporations, also called small business corporations.
There are significant differences between these types of corporate taxation. You can elect to have your LLC taxed either way.
C corporation taxation
C corporation taxation is the default mode of taxation for LLCs that elect to go this route.
Unlike a sole proprietorship, a C corporation is a separate entity from its owners for income tax purposes. Profits and losses do not pass through to the owners’ individual tax returns as they do with the sole proprietorship form of taxation.
Instead, C corporations must pay income taxes on their net income and file their tax returns with the IRS using Form 1120, U.S. Corporation Income Tax Return.
An LLC taxed like a C corporation pays income tax only on its net profit for the tax year. And it pays this at the corporate tax rate, not your personal income tax rates.
Your LLC gets to deduct from its income all of its business expenses, including employee salaries, most fringe benefits, bonuses, and operating expenses like office rent.
However, an LLC taxed like a corporation does not benefit from the up to 20% pass-through tax deduction established by the Tax Cuts and Jobs Act. This deduction can cut the effective tax rate for LLC members taxed as sole proprietors by 20%.
You don’t pay tax on your taxed-like-a-C-corporation LLC’s earnings unless you receive the money as compensation for your services (salaries and bonuses) or as dividends. The LLC itself pays taxes on all profits left in the business.
The Tax Cuts and Jobs Act dramatically reduced the C corporation tax rate to a single flat tax of 21%. This replaced tax rates ranging from 15% to 35% that corporations paid before 2018.
C Corporation Income Tax Rate
Taxable Income Tax Rate All over $0 21%
The 21% rate is lower than individual rates at certain income levels. However, this doesn’t necessarily mean you’ll save any tax with C corporation taxation on account of double taxation.
With C corporation taxation, any direct payment of your LLC’s profits to you is a dividend for tax purposes and taxed twice. First, the LLC pays corporate income tax on the profit at the 21% corporate rate on its corporate return.
Then you pay personal income tax on what you receive from the LLC at capital gains rates. These can be as high as 20% (higher income taxpayers must also pay an additional 3.8% Medicare tax).
When you add the personal tax on dividends to the 21% C corporation income tax, the combined tax is often higher than the income tax a single-member LLC owner taxed as a sole proprietor would pay at his or her individual rate on a like amount of income.
S Corporation Taxation
You can also elect to have your LLC taxed as an S corporation instead of a C corporation. Unlike a C corporation, an S corporation pays no tax itself. Instead, income and losses pass through the corporation to the owners’ personal tax returns. Therefore, individual rates apply to these taxes.
When you choose this method of taxation, your LLC files an S corporation information return using IRS Form 1120-S, U.S. Income Tax Return for an S Corporation. This form lists the LLC’s income and deductions.
You file IRS Schedule E with your personal tax return (Form 1040), showing your share of the LLC’s income. You add this amount to any other income on your return.
Thus, with S corporation taxation, your LLC profits get taxed at your individual income tax rates. In similar fashion, like when your LLC pays taxes as a sole proprietorship or partnership.
There is no double taxation as with C corporations. Also, you can qualify for the pass-through deduction if you choose S corporation taxation for your LLC.
The main reason people choose S corporation taxation is that it can save Social Security and Medicare taxes. You do not have these on distributions (dividends) from your LLC taxed S corporation—that is, on earnings and profits that pass through the LLC to you as the owner. The S corporation is the only business form that makes it possible for its owners to save on these taxes.
Your employment status when you choose corporate taxation
When you choose to have your LLC taxed as a C or S corporation, you must become your LLC’s employee if you actively work in the business.
To clarify, your LLC will have to pay employee payroll taxes, withhold income and Social Security and Medicare taxes from your pay and send it to the IRS and file employment tax returns. In addition, they likely have to provide you with unemployment insurance coverage.
Your LLC must pay you reasonable employee compensation for your work. You must pay tax on your employee salary, bonus and other taxable payments from your LLC at your individual tax rates. The LLC gets to deduct employee salaries and benefits from its taxable income, so there is no double taxation on these payments, but there are no tax savings either.
