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How Is an LLC Taxed? – The Complete Guide to LLC Taxes

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Published on January 13, 2022

Updated on January 15, 2022

How Is an LLC Taxed? – The Complete Guide to LLC Taxes

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How Is an LLC Taxed? – The Complete Guide to LLC Taxes

If you’re starting a business and considering forming a limited liability company (LLC), you need to understand what will happen at tax time. LLCs offer many benefits when it comes to taxes. 

An LLC is a business entity that offers liability protection for owners, as well as pass-through taxation, much like a sole proprietorship. To learn more about LLCs, read this Step By Step article.

How LLCs are Taxed

LLCs are unique in terms of taxation as their owners have a choice about how the company will be taxed. By default, an LLC is taxed like a sole proprietorship if it has one member, and like a partnership if it has more than one member.

In both cases, business income “passes through” the company to the members, who report profits and losses on their individual tax returns. The LLC itself is not taxed, which simplifies the process for members. Also, losses and operating costs of the business can be deducted personally by the members. Taxes are paid at the personal tax rate of the members, although the owners may also have to pay self-employment taxes. 

LLC owners also may be eligible for the 20% pass-through deduction that was part of the Tax Cuts and Jobs Act, meaning they can deduct up to 20% of business income. Note that a multi-member LLC must also file form 1065 with the IRS, which is the U.S. Return of Partnership Income. Attached to this will be K-1 forms showing each member’s share of the business income. 

But LLCs owners can instead choose to be taxed as a corporation. To do so, the LLC must file a document, referred to as an election, with the Internal Revenue Service (IRS). The LLC must then decide if it wishes to be taxed as an S corporation or a C corporation.

C Corp status means profits are taxed at the current rate for corporations (21% as of early 2022), which is significantly lower than the typical individual taxpayer rate. But keep in mind, C Corp shareholders, which includes members, must also pay taxes on their distributions (but not self-employment taxes). Thus, the C Corp is subject to what is sometimes referred to as double taxation. 

As with sole proprietorship and partnership status, S Corp taxation considers the LLC a pass-through entity, which means income passes through the company and into the hands of the owners. At this point, taxes are applied at the same rate as those of individual taxpayers.

S-Corps use Form 1120S to file their taxes, which is used to report the income, losses, and dividends of S corporation shareholders. S-Corp shareholders do not pay self-employment taxes, which is the primary advantage of S-Corp status compared to sole proprietorship or partnership. 

Generally, S-Corp tax status is beneficial if the company is profitable enough to pay the owners a salary and at least $10,000 in annual distributions so the owners can be taxed as employees and not pay self-employment taxes. It costs more to run an S-Corp than an LLC due to additional bookkeeping and payroll expenses. Thus, the tax benefits should be more than the additional costs for an S-Corp status to make financial sense. LLCs offer additional benefits to owners as well.

Benefits of Forming an LLC

  1. Simplicity. An LLC is simple to form, requiring much less paperwork than a corporation. You only need to file Articles of Organization and have an Operating Agreement to define ownership and roles and responsibilities. There are no annual meeting or reporting requirements, as with a corporation, and you don’t need a board of directors. In some states, however, you do have to file an annual report for an LLC. It’s also less expensive to form an LLC. Corporations and partnerships are best formed with the assistance of an attorney, which is expensive. It is a good idea, however, to have your LLC’s operating agreement reviewed by an attorney. Corporations also pay fees for their required annual filings.
  2. Control. In an LLC, you can be the only owner just like a sole proprietorship so that you have full control of the business. If you have more than one owner, you can structure the management any way you choose with your operating agreement. You don’t have to answer to a board of directors or anyone else. You have more freedom to make decisions than you do in another type of business structure, other than a sole proprietorship.
  3. Limited Personal Liability. Unlike a sole proprietorship, an LLC is considered a legal entity that is separate from you, as the owner. Just as in a corporation, your personal assets are protected because you are not personally liable for the company’s debts or legal liabilities. In a sole proprietorship or general partnership, your personal assets such as your home are at risk if there are unpaid debts or legal liabilities. There are some instances in which an LLC owner, however, could have personal risk. For example, if you are asked to personally guarantee a business loan, you are personally liable for the debt.
  4. Profit-Sharing Flexibility. Most businesses split profits based on the capital contributions of owners. In a partnership, profits are generally divided equally. Corporations pay dividends based on the ownership percentage of the shareholders. In an LLC, in the operating agreement, the owners can specify any profit-sharing plan that they choose. One owner can take a percentage share of profits greater than their ownership interest, while other owners take less. This may be done in a case in which one owner is more involved in the operations of the business than others. 
  5. Credibility. An LLC has the advantage of having more credibility to customers and vendors than a sole proprietorship. As a matter of perception, people tend to see an LLC more as a more established company, as opposed to a one-person show.

In Closing

LLCs have several tax benefits, including the fact that you can choose how your LLC will be taxed. LLCs offer other benefits as well, most importantly, personal liability protection. Before forming your LLC, it’s a good idea to seek the advice of an attorney and tax advisor to make sure an LLC is the right type of business entity for you.