You know what they say about death and taxes: they’re unavoidable. For taxes, it’s especially true if you’re running a business.
This is why the LLC’s variable tax structure has made it an extremely popular business structure. Thousands of new LLCs are formed every day in America and, while they shoulder less of a tax burden than most corporations do, there are still a few important facts that you should know about how LLCs pay taxes.
From the way limited liability company owner/members claim profits and losses, to how single-member and multi-member LLCs are taxed differently, this article serves as a how-to guide, clarifying some of the most overlooked and misunderstood aspects of state and federal LLC taxation.
So, let’s get on with it. Here are the 10 things every entrepreneur should know about LLC taxes.
1) LLCs Don’t File Corporate Tax Returns
That sounds nice, doesn’t it? In most cases, limited liability companies are exempt from their own corporate income taxes. They’re considered “pass-through” entities, so an LLC’s owners are responsible for reporting business profits and losses on their personal returns rather than on a separate return for the entity itself. The biggest benefit here 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
In the eyes of the IRS, single-member LLCs are the same as sole proprietorships for taxation. 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 the simple taxation of a sole proprietorship, while still providing its owners with limited liability protection, one of the LLC’s biggest advantages.
3) Multi-Member LLCs Are Typically Taxed Like Partnerships
But what about multi-member LLCs? By default, they’re taxed like general partnerships. Like the single-member LLC, 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 to 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
If you like having choices, you’re in the right place, because the LLC offers plenty. Don’t want to have your LLC taxed like a sole proprietorship or general partnership? You can elect to have it taxed as a C corporation or an S corporation instead. The C corp is the most common form of corporation because there aren’t many restrictions on which businesses can claim C corp status. The big drawback of the C corp is the double taxation we mentioned earlier.
S corps have a lot more operational intricacies. For example, they must limit the number of shareholders, only issue one class of stock, and more. To elect S corp taxation, an LLC must not have any foreign owners, but other than that, there aren’t many restrictions.
The main reason to elect 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 simply stick with the default partnership-style taxation.
5) LLC Owners Can Choose How to Split up the Shared Tax Burden
Not only can your multi-member LLC choose its tax structure, but it can also choose how to split up the tax burden between members. This way, you can discuss with your fellow owners how much each person should be accountable for, so that everyone is content and on the same page.
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
Contrary to what you might think, each LLC owner is not considered an employee of the company. Instead, the IRS sees them as self-employed and therefore responsible for a self-employment tax. This includes both the employer and employee portions of Medicare (2.9%) and Social Security (12.4%).
15.3% of the net income isn’t a small amount, so you’ll want to be aware of this tax when compiling your personal and business budgets. The only exception to this is when an owner reaches the $128,400 Social Security taxation threshold for annual net income― after this, that particular owner only needs to pay the 2.9% Medicare portion on the rest of their income.
7) LLC Owners Need to Pay Estimated Taxes
Okay, so there’s the self-employment tax, but that’s not where an LLC owner’s tax responsibilities end. Because they’re self-employed, there are no employer withholding taxes from their 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
In the same way that individuals use a social security number to identify themselves on tax forms, businesses use an employer identification number (EIN). 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 to obtain an EIN 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.
It might sound complicated, but don’t worry, it’s actually pretty easy. Obtaining an EIN is as simple as filling out the IRS website’s EIN Assistant application. As soon as you finish the application, you’ll receive a confirmation notice that allows you to open a business bank account, apply for business licenses and/or permits, and more. 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 electronic payments.
9) Forming In Another State Doesn’t Typically Help Avoid Taxes
We’ve all heard the stories of how states like Nevada and Wyoming are considered tax havens because of their lack of business income taxes. Quite a few entrepreneurs look to avoid tax expenses by forming their limited liability companies in these states, rather than in their own state.
But this isn’t often the case. Let’s say you live in Nebraska and want to operate your business there, but are considering forming your LLC in Nevada to take advantage of its tax benefits. This wouldn’t actually help much, 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
If you’re coming to the U.S. from another country and you want to establish an LLC, you’ll need a taxpayer identification number (TIN). The TIN is a substitute for a social security number, allowing you to pay taxes on your business. To acquire a TIN, fill out Form W-7 and file it with the IRS. What’s nice is that this form is actually multi-functional, also allowing you to establish your alien status and your identity.
All things considered, taxation for LLCs is far simpler than it is for corporations. Even so, you never want to dive into a new business entity without fully understanding its tax implications. Your LLC’s income is going to be taxed one way or another, and now you know the exact procedures so you’ll be ready come tax time.
Keep these ten facts in mind while operating your business and 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. Don’t be afraid to give them a call!
While you can’t avoid taxes, you can prepare for them, which makes the process a whole lot easier. As you progress in the life of your LLC, don’t forget about the tax specifics and it’ll be smooth sailing.