Limited liability companies are incredibly popular business entities, as thousands of new LLCs are formed every day in America. While LLCs shoulder less of a tax burden than most corporations do, there are still quite a few important facts that you need to know about how LLCs pay taxes.
From the way limited liability company owner/members claim profits and losses, to how LLC taxes work regarding single-member and multi-member companies, this article serves as a how-to guide of sorts, taking a look at some of the most overlooked and misunderstood aspects of LLC taxation, both on the federal level and the state level.
With that, let’s take a look at 10 facts about LLC taxes that you need to see.
1) LLCs Don’t File Corporate Tax Returns
When it comes to business tax returns, the limited liability company is (usually) exempt from filing, due to the pass-through nature of LLC taxes. With most LLCs, profits and losses aren’t claimed by the business entity itself, but are instead passed through the company to its owner/members, who then claim this income on their personal tax returns.
The biggest benefit of this is that unlike most corporations, LLCs avoid double taxation, which is when the same money is taxed twice ― first on the corporate level, then again when a shareholder files their individual taxes.
2) Single-Member LLCs Are Taxed Like Sole Proprietorships
For taxation purposes, there isn’t much of a difference at all between the single-member limited liability company and a sole proprietorship. All the owner needs to do is claim the net income from their LLC using a form called Schedule C, then transfer that information to a Form 1040 when filing their individual tax return.
In this way, the single-member LLC retains one of the major advantages of a sole proprietorship (the ease with which taxes are paid), while still receiving the biggest benefit of the LLC, which is the limited liability protection it affords its owners.
3) Multi-Member LLCs Are Typically Taxed Like Partnerships
While limited liability companies with more than one member have options regarding how they want to be taxed (more on this shortly…), the default tax status for these LLCs is similar to a partnership. Like the single-member LLC, the net income passes through the business entity to each owner, who is then responsible for paying their share of taxes to the IRS.
Instead of filing a business tax return, an LLC with more than one member will only submit an informational report called a Form 1065 with the Internal Revenue Service, which describes the total tax burden for the company so that the IRS knows how much to expect from each member.
4) An LLC May Elect C Corporation or S Corporation Taxation
An exception to the guidelines above occurs when the limited liability company’s owners choose to have their business taxed like a corporation ― either as a C corporation or as an S corporation. The C corp is the most common form of corporation, because there aren’t many restrictions on what businesses can claim C corp status. The big drawback of the C corp is the double taxation we mentioned earlier.
As for the S corp, there are many intricacies that corporations must follow to operate as an S corp, like limiting the number of shareholders, only issuing one class of stock, etc. For LLCs to elect S corp taxation, they cannot have any foreign owners, but otherwise there aren’t too many restrictions.
The main reason for electing C corp or S corp taxation is if the LLC member/owners are high-income individuals who would benefit from corporation-style taxes. The vast majority of LLCs do not choose to be taxed in this manner, but rather stick with the partnership-style taxation that is the default.
5) LLC Owners Can Choose How to Split up the Shared Tax Burden
One of the main reasons so many entrepreneurs love the limited liability company as a business entity is because it provides options. One of those options is how a multi-member LLC chooses to split up the tax burden that’s shared between its members.
Obviously, the most common option is to split the net income ― and therefore, the tax burden ― equally among all of the LLC’s owners. However, if you have some owners who are more active in business operations than others, or if certain owners contributed more capital to the business, you can divvy up each individual’s portion any way you’d like.
6) LLC Owners Need to Pay Self-Employment Tax
Because the ownership of a limited liability company is considered to be self-employed, each owner is responsible for paying their share of self-employment tax to the IRS. Self-employment taxes include both the employer and employee portions of Medicare (2.9%) and Social Security (12.4%).
Therefore, each owner needs to pay 15.3% of the net income they receive from the LLC as self-employment tax. The only exception to this is when an owner reaches the $128,400 Social Security taxation threshold ― after reaching this milestone for annual net income, that owner only needs to pay the 2.9% Medicare portion on the rest of their income.
7) LLC Owners Need to Pay Estimated Taxes
As we’ve already established, limited liability company owners are self-employed. Another result of this employment status is that no one is withholding taxes from your income. Because of this, each owner needs to pay estimated taxes to the IRS every quarter.
IRS guidelines suggest that each owner pay at least 90% of their total tax obligation through estimated taxes. If an owner fails to do so, they may be required to pay an estimated tax penalty. Each year, the estimated tax payment dates vary slightly, but in general they fall right around the same time: April 15 for the first quarter, June 17th for the second quarter, September 16 for the third quarter, and January 15 for the fourth quarter.
8) Most LLCs Need to Acquire an EIN
A federal tax ID number (also known as an employer identification number, or EIN) is a necessity for most limited liability companies. Your LLC will need an EIN if you have employees, and they’re also usually required to open business bank accounts. There are also a number of other requirements for EIN obtainment that only apply to a small portion of LLCs, like those that need to file specialized tax returns, or those that have a Keogh plan.
Getting an EIN is a simple process that involves filling out the EIN Assistant application on the IRS website. As soon as you finish the application, you’ll receive a confirmation notice that allows you to do things like open a business bank account, and apply for business licenses and/or permits. However, you will need to wait until the IRS enters your EIN into the permanent record to use it for electronic tax return filing, or making electronic payments.
9) Forming In Another State Doesn’t Typically Help Avoid Taxes
We’ve all heard the stories of how some states are considered tax havens because of their lack of business income taxes ― for example, states like Nevada and Wyoming fit this description. Therefore, quite a few entrepreneurs think it’s a good idea for tax purposes to form their limited liability companies in these states, rather than in their own state.
However, if you live in Nebraska (for example) and also operate your business there, it doesn’t help much to form your LLC in Nevada, because you’ll still be responsible for taxes on your Nebraska-based business transactions. If anything, you’ll end up with more compliance responsibilities and more startup/maintenance fees for your LLC, with very few benefits to show for it ― especially considering that you’ll need to register your business as a foreign LLC in your home state.
10) Non-U.S. Citizens Will Need a TIN
While there are very few differences when it comes to limited liability company ownership for Americans and non-Americans, one major disparity is that anyone who isn’t a U.S. citizen will need a taxpayer identification number (TIN). Because people who don’t live in America don’t have Social Security numbers, the TIN substitutes for the SSN to enable the owner to pay taxes.
To acquire a TIN, you’ll need to fill out Form W-7 with the IRS, which is the document where you can establish your alien status as well as your identity.
All things considered, tax issues for limited liability companies are far simpler than those of corporations. Still, there are certainly plenty of important aspects to keep in mind when forming and operating an LLC, because the money generated by your business is still going to be taxed one way or another.
If you keep these ten facts in mind regarding your LLC’s tax obligations, we’re confident that you won’t run into any trouble with the Internal Revenue Service. If you end up having any questions or concerns, you might be surprised by how helpful the IRS can be if you simply ask.
We hope this article helped you develop your understanding of LLC taxation rules, and we wish you the best of luck!