Because a limited liability company (LLC) is a pass-through tax entity, it means that profits pass through the company to individual members. As a result, the individual members (rather than the company) must report the members’ share of the profits on their individual tax returns. The IRS treats an LLC as a sole proprietorship, a partnership, or, if the LLC elects, as a corporation for tax reasons.
Filing Federal Income Taxes as a Multi-Member LLC
The IRS automatically treats an LLC with more than one member as a partnership, unless the LLC opts for tax treatment as a corporation. Like a business partnership, the LLC must file Form 1065 (U.S. Partnership Return of Income), which includes a Schedule K-1. The LLC must report the profits and losses that pass through to each member on individual Schedule K-1 forms. Each member must report this information on a 1040 tax return and attach a Schedule E.
The IRS requires LLC members to pay taxes on their distributive share of the profits. In general, a distributive share is equal to the percentage of each member’s interest, but the LLC can distribute profits disproportionately. This is referred to as “special allocation.” Regardless of whether the LLC actually distributes any of a member’s distributive share, each member must still pay taxes on their entire distributive share.
Paying Self-Employment Taxes
The IRS requires LLC members to pay federal self-employment taxes on the profits received. Members must pay self-employment taxes if the member is “active in the business.” As a guideline, this means that the member participates in the trade or business for more than 500 hours in the tax year or the member works in an LLC that is a professional service business in the field of health, law, engineering, architecture, accounting, actuarial, or consulting. The IRS may not require non-active LLC members to pay self-employment taxes.
Members must report self-employment taxes on a Schedule SE. LLC members are responsible for paying the entire 15.3% (12.4% for Social Security and 2.9% for Medicare). Members can deduct half of the self-employment tax from their adjusted gross income.
Filing Federal Income Taxes as a Single Member LLC
When an LLC has a one member, the IRS automatically classifies it as a sole proprietorship for tax filing purposes. The member of the LLC must file a 1040 income tax return and report profits and losses on a Schedule C (“Profit or Loss From a Business”).
Paying Estimated Taxes
Taxpayers employed by an employer pay taxes through withholdings from a paycheck. Because profit distributions made to members in an LLC do not include tax withholdings, LLC members must pay estimated taxes on a quarterly basis to the IRS and to state governments (if applicable), similarly to self-employed taxpayers.
Filing State Income Taxes
LLC members must also file state income tax returns. Like the federal government, most states allow LLC members to pay taxes on profits through personal tax returns. A few states also require members to pay an additional tax on the income made by the LLC. For instance, a member may have to pay a tax on LLC income that exceeds a certain amount. Other states may require the LLC to pay an annual fee, sometimes called a “franchise tax” or a “renewal fee.”
Electing Corporate Tax Treatment
A limited liability company can choose corporate tax treatment. Because LLC members must pay taxes on all profits, this option may be beneficial if the LLC chooses to keep a significant amount of profits will in the business to contribute to the LLC’s growth.
It may also save individual members on taxes: corporate tax rates range from 15% to 34% on net taxable income under $100,000 and 39% on net taxable income between $100,001 and $335,000. Individual tax rates range from 10% to 35%, but on average, individual taxpayers pay from 27.5% to 35%. An LLC may elect corporate tax treatment by filing Form 8832 with the IRS and the LLC must file Form 1120 each year the election applies.