LLCs are flexible and worthwhile company models that many businesses opt to transition to once they reach a certain level of growth or if they have multiple owners interested in doing business together over the long-term.
Some of the biggest benefits that LLCs provide to their owners include various tax reductions. However, it's important to understand how LLC taxes work so that you're prepared to file for them correctly at the end of the fiscal year.
What is an LLC
An LLC or limited liability company is essentially a type of hybrid business structure that offers many of the benefits of corporations and partnerships while retaining plenty of flexibility for business owners. Furthermore, LLCs protect business owners and members from liabilities related to business activities, debt accrued, and other circumstances.
Both small and large businesses alike often form LLCs due to their flexibility, additional benefits, and the advantages they then get during tax season.
How Are Limited Liability Companies Taxed?
Unlike corporations, limited liability companies aren't considered to be separate tax entities. Instead, the IRS calls most LLCs "pass-through" entities by default, which are similar to sole proprietorships or partnerships.
As a result, all of the profits and losses of a given LLC end up "passing through" the business to the owners or members. This allows LLC members to report income from the business as personal income on their tax returns.
Thus, LLCs do not pay federal income taxes by default, aside from the small caveat that some states impose annual tax rates for all LLCs that operate within their borders.
Again, the IRS treats an LLC like a partnership or sole proprietorship. Which is which depends on how many members are included in the LLC.
A single-owner LLC is ideal for smaller businesses that only have one owner or primary member. In this case, the IRS treats any single-member LLCs as sole proprietorships.
The resulting LLC doesn't pay any taxes and does not need a file a separate tax return with the IRS. However, all income from that LLC must be reported on the sole owner's tax returns on Schedule C. The income must be submitted with a regular 1040 tax return.
Most LLCs include multiple members or owners. In these cases, the IRS treats LLCs like partnerships. Such LLCs don't pay separate taxes on business income. Instead, each LLC owner will pay individual taxes on their share of the profits by putting those profits on their personal income tax returns.
The distributive shares for an LLC's profits and losses are outlined during an LLC's Operating Agreement, which is a defining document for how the company is run and organized.
The vast majority of LLCs dictate membership distributive shares that are proportionate to their percentage of interest in the business. For example, a primary owner may own 60% of an LLC. Thus, that primary owner will be entitled to 60% of all the LLC's profits and losses.
Furthermore, the IRS treats every LLC member as though they receive their entire distributive share every fiscal year, regardless of whether or not the LLC actually distributed those profits. Thus, LLC members must still pay income tax on the projected earnings even if that money isn’t their bank accounts come tax season.
One of the great tax-related benefits of LLCs is that they can "elect" for corporate taxation instead. This will result in the LLC being treated as a corporation by the IRS for certain tax purposes. All they have to do is file the IRS Form 8832 and fill it out appropriately.
As of 2018, any normal or "C" classified corporations are taxed at a 21% flat rate on any profits or income. This is a much lower rate than the highest three individual income tax rates, which can vary from between 32% up to 37%.
Therefore, many LLCs that earn significantly higher income as they grow may decide to elect for corporate taxation so their members collectively pay less in taxes than if they each filed individually.
This is not always the case, however. Some of the money distributed from a regular corporation could be subject to double taxation under certain circumstances. For example, the 21% corporate tax rate must be applied. Afterward, each shareholder has to pay individual income tax on any dividends at capital gains rates. These can go up to 23.8%.
What is Tax-Deductible for an LLC?
Many LLC members looking to tax deductions so they pay less in taxes at the end of the year.
As with most regular business operations, LLC members can deduct any legitimate business expenses from their income. This can result in much lower profits reported to the IRS. These deductible expenses include:
- travel and infrastructure expenses
- the costs to operate equipment
- advertising and marketing costs
- and more
Alternatively, LLC owners can opt for a flat 20% tax deduction for their net income for their company. This is much easier and may be worthwhile for companies that do not spend quite so much on operating expenses due to their business model or industry.
Other LLC Taxes
In addition to the above tax rules, LLC members must account for self-employment taxes because they technically employ themselves, rather than being the employees of a separate business they do not own. This applies to both multi-member and single-member LLC owners.
Additionally, LLCs must pay state profit taxes. The rates are derived from personal tax return amounts. LLCs do not pay separate state taxes, with the exception of a few states such as California. Even in this case, the state tax rate only applies to LLCs that make more than $250,000 per year.
How LLCs Pay State or Federal Income Tax
LLCs, when filing as a corporation or for other purposes, may simply file taxes with the IRS with a separate document from their owners.
A domestic limited liability company that has at least two members should file federal income taxes using Form 8832 and elect to be treated as a corporation.