How is an LLC taxed: what are your options?

Considering setting up your business as a limited liability company (LLC)? Perhaps your business is growing and becoming more complex. Maybe you wish to manage your exposure to risk as a business owner. Or, possibly, you are eyeing the potential LLC tax benefits that come along with this entity type.

As you weigh the pros and cons, you may have questions. How is an LLC taxed? How do LLC taxes work? What are the benefits of an LLC? We can help you find the answers.

A limited liability company (LLC) is a business entity registered under state law to offer limited liability protection for its owners or “members.” Your business may be a single-member LLC if you are running the company on your own. Or it can be a multi-member LLC if you have business partners.

However, an LLC is not an IRS-recognized business structure for federal taxes. Rather, with an LLC, you get to choose how you’ll be taxed. Read on, and we’ll explain.

How do LLC taxes work?

As an LLC, you could have up to four options for how to pay federal taxes. Your company may be eligible to elect the sole proprietorship, partnership, C Corporation, or S Corporation tax classification.

• Sole proprietorship. By default, the Internal Revenue Code taxes a single-member LLC as a sole proprietorship. You may see it formally referred to on tax forms as a “disregarded entity.” This label means the LLC does not pay taxes separately from its owner. Instead, the business income and expenses from the company pass through the LLC to the business owner. The Internal Revenue Service “disregards” the entity for tax purposes. The single member files taxes on the amount earned each year. Individuals use Schedule C, which is part of the individual tax return Form 1040.

• Partnership. By default, the IRS taxes a multi-member LLC as a partnership. Like the sole proprietorship, LLC partnership taxes pass through the entity to the business owners. You’ll file IRS Form 1065 with the IRS on behalf of the LLC annually by March 15. Then, a Schedule K-1 is issued to each member so that they can report their portions of the annual profits and losses from the business on their own individual income tax returns.

Here’s where the choice comes in. Your single-member or multi-member LLC can proactively elect to be taxed as a C or S Corporation. Choosing either status won’t affect your LLC as a business entity. You’ll continue to operate as an LLC, but the way your income is taxed will change.

• C-corporation. To choose this status, file Form 8832  for a C Corporation (then file Form 1120 annually). If you file as a C Corp, the company’s net income will be taxed twice – first at the corporate level and then again (albeit at a favorable rate) when the after-tax profits are distributed to shareholders as dividends. This is known as “double taxation.” For more about C Corps, see our post on LLC vs. C Corps.
• S-corporation. To choose this status, file a Form 2553 for an S Corporation if your business is eligible (then file the 1120-S tax form annually). If you elect to follow this path, your organization becomes a pass-through entity, as described below, effectively avoiding “double taxation.” The important thing to know is that taxes on income from an S Corp are assessed at the owners’ individual rates. Learn more about S Corps in our post: S Corp vs LLC.

Want to learn more about business registration tax election implications? We’ve got your back. Block Advisors has the information and tools to help you navigate this important topic for your company.

What are the tax benefits of an LLC and what are the drawbacks?

Choosing a particular tax entity is a result of looking at several different factors, one of which is tax treatment. As a member of an LLC, you can take advantage of some tax benefits. But keep in mind that there may also be some drawbacks. A smart business owner weighs the good and the bad.

LLC tax benefits

• Pass-through income. When using a sole proprietorship, partnership, or even an S Corporation tax option, the LLC becomes a pass-through business entity. As such, profits and losses are passed directly to the members without the business entity paying federal taxes on the amount. Many LLC members view this benefit as a clear advantage over the double taxation method required for a C Corporation. As mentioned above, due to double taxation, C Corp profits are effectively taxed twice. First on a company level, then again when the LLC owner pays taxes on the dividends.  

• Flexibility. With an LLC, you can choose how the business is taxed, whether that be as a sole proprietorship, partnership, or corporation. The default rules for sole proprietorship and partnership don’t require the filing of additional tax forms to make this choice. However, electing the corporation option does require an additional filing. Furthermore, it is important to understand that if you choose to change your classification after forming your LLC and selecting your initial classification, you will be locked into your new choice for the next 60 months.

• Corporate tax without the corporation. An LLC allows a business to be taxed as a corporation without forming one. LLCs are generally less expensive to operate, may involve less paperwork, have fewer formalities, and have lower administrative burdens than a corporation formed under state law.

LLC tax drawbacks

• Self-employment tax. LLC members taxed as a sole proprietor or partner must pay self-employment taxes. You’ll pay both the employer and the employee portions of self-employment tax using Schedule SE when filing Form 1040.
  
• Estimated tax payments. LLC members taxed as sole proprietorships or partnerships are typically required to make timely estimated tax payments. Once every quarter, you’ll make an estimated tax payment based on what you may owe at the end of the year in federal taxes. LLC members may need to make estimated tax payments at the state level as well.
  
• Tax limits on deductions. As an LLC member, you may have some tax limits on what you can deduct on your federal tax return. For example, in an LLC taxed as a partnership, an LLC member’s annual losses may be limited to their adjusted tax basis for their membership interest at the end of the tax year.

To illustrate, consider Thomas’ home improvement company. Last year the business recorded a net loss of $10,000. Thomas holds a 30% membership interest in the LLC. So, his share of the loss is $3,000 ($10,000 x 0.30). If Thomas had a basis of $2,000 in his LLC interest, his deductible loss would be limited to $2,000.

Want more help with LLC tax questions?

While we’ve covered how an LLC is taxed and how LLC tax options work, you may still have questions about what’s right for your small business. Learn more about business registration and entity tax classifications with our Entity 101 post.

For hands-on support, a trusted Block Advisors certified small business tax pro can help. Our tax pros have the expertise to walk you through the tax implications specific to your business. We also have business formation products to equip you with information and help you navigate the entity registration process.

Find a tax pro >>

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FAQs

Are most LLCs taxed?

Yes, most LLCs are taxed. Although it’s possible for an LLC to obtain tax-exempt status, the majority of LLCs will either pay tax at the entity level or the income will pass through to the owners, who pay taxes on it.

What is an LLC usually taxed as?

How an LLC is usually taxed depends on the number of members it has. LLCs that have only one member are taxed as a disregarded entity. This means they report business income on the owner’s personal tax return unless they choose otherwise. If the LLC has multiple owners, it is taxed as a partnership by default.

What are the advantages of having an LLC?

There are many benefits of forming an LLC including limited liability protection, flexibility of management, freedom to choose how the business is taxed, and fewer administrative formalities compared to other entity structures. There are other advantages that may apply depending on your personal and business situation.

What are the cons of an LLC?

There are some disadvantages to forming an LLC.  From a tax perspective, by default, owners are subject to self-employment tax on their share of the business’ profits and may need to make estimated tax payments.

Outside of taxes, there is some paperwork involved in creating and maintaining an LLC (as compared to a sole proprietorship).  Documents must be filed with the state and maintained over time, and fees typically apply.  Additionally, the LLC may cease to exist if a member dies or quits.

What are the tax disadvantages of an LLC?

Although LLCs get to choose how they are taxed, there are few tax disadvantages for LLCs. One of the major ones is that if the LLC chooses the default tax classification, then owners are subject to self-employment tax on their share of the business’ profits. Owners may also have to make estimated payments to account for their share of the business’ income.   Finally, if an LLC changes its tax classification, it cannot change it again for 60 months.

How does an LLC avoid double taxation?

An LLC can avoid double taxation by electing to be taxed as a pass-through entity. If the LLC has just one member, that owner can choose to be taxed as either a disregarded entity ( and pay business tax on their individual return) or an S Corporation to avoid double taxation. If it has multiple members, it can choose either partnership or S corporation taxation.

Should I pay myself a salary from my LLC?

Whether you pay yourself a salary depends on a couple of factors, the first being whether you work for the business. If you don’t perform services for the business, then you shouldn’t draw a salary. Assuming you are performing services for the business, the other factor to consider is how the LLC is taxed.

If the LLC is taxed as a sole proprietorship or partnership, you cannot draw a salary as a W-2 employee. For those taxed as partnerships, you may be able to receive guaranteed payments, but you would receive them as a partner, not an employee.

If your LLC is taxed as a C or S Corporation, then you will be treated as an employee if you are performing services for the business. For LLCs taxed as an S Corporation, the salary that you receive must be reasonable.

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