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LLC Pass-Through Taxation: What is it and How Does it Work?

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Published on December 30, 2021

Updated on January 4, 2022

LLC Pass-Through Taxation: What is it and How Does it Work?

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LLC Pass-Through Taxation: What is it and How Does it Work?

If you’re thinking of making your new business a limited liability company (LLC), you may have heard the term “pass-through taxation”. Taxes are a key consideration when choosing your business structure, so you should understand what this means, and how an LLC differs from other business entities. 

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, read this Step By Step article on LLCs.

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 a partnership if it has more than one member.

In both cases, business income “passes through” the company to the members and profits and losses are reported 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 members’ personal tax rates, though the owners may also have to pay self-employment taxes. 

Note that a multi-member LLC must also file form 1065 with the IRS, which is the Return of Partnership Income. Attached to this will be K-1 forms for each member showing their 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 makes the LLC a pass-through entity, which means owners pay taxes at their personal rates. 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. 

How You Can Pay Yourself

Regardless of your tax status, you may be wondering how you actually get paid as an LLC member. As the owner of a single-member LLC, you’re able to receive all of the profits. If the company makes $100,000, for instance, you can receive $100,000.

You can receive distributions all at once, or you can receive portions periodically. To pay yourself distributions, simply write yourself a check from the business bank account. Then record the withdrawal on your books as an owner’s draw, which reduces your owner’s equity account.

You will report all profit, not just your draws, on Schedule C of your personal tax return. You’ll also be required to pay self-employment taxes on your draws.

In a multi-member LLC, members of the LLC can also take draws from the profits. Draw amounts are based on each member’s ownership percentage. For example, if there are two members and each owns 50% and the business makes $100,000, each member can draw $50,000.

If you have a multi-member LLC and you have not elected to be taxed as a corporation, you will be taxed as a partnership, but the partnership is a pass-through entity. A multi-member LLC must file form 1065 with the IRS, which is the Return of Partnership Income. Attached to this will be K-1 forms for each member showing their share of the business income. Form 1065 is for reporting purposes only. The LLC itself does not pay taxes.

Each member pays taxes on their share of profit based on Schedule C of their personal tax return, as well as self-employment taxes. If you are taxed as a corporation, you cannot be paid in draws from your LLC.  You must be paid as an employee of the LLC.

To become an employee, you’ll file a W-4 form. Then you can pay yourself a salary and will receive a W-2 for tax purposes. You must have an active role in the LLC to be an employee. If you are a silent member, uninvolved in LLC operations, you cannot receive a salary or be an employee. If your LLC has more than one member and all members play active roles in the company, you cannot receive a salary if the other members are not salaried. Either all active members receive a salary, or none do. 

The wages you’re paid will be an expense of the LLC, deducted from profits just like any other expense. Per IRS rules, your salary must be within industry norms for the role you play, so you can’t pay yourself an unreasonable amount. Keep in mind, as an employee, income tax and employment taxes will be withheld from your salary checks.

If there are profits left after your salary, you can take your share of the LLC profits as a shareholder distribution for an S Corp, or a dividend as a C Corp.

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 dividends (but not self-employment taxes). Thus, the C Corp is subject to what is referred to as double taxation. 

As with sole proprietorship and partnership status, S Corp taxation makes the LLC a pass-through entity, which means owners pay taxes at their personal rates on a Schedule C. 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. 

In Closing

Nobody likes to think about taxes, but they are inevitable, and if you don’t do them right, the consequences can be devastating. LLC pass-through taxation is fairly straightforward, but it’s still recommended that you get the advice of your tax advisor to make sure an LLC is right for your business and that you take all the necessary steps at tax time. 

You can learn more from this Step By Step article on starting an LLC.