How Do Limited Liability Companies (LLCs) Pay Taxes?

When you start a business and form a limited liability company (LLC), you step into a brand new world. One major hurdle is the dreaded T word – taxes. Nobody enjoys taxes, and as an LLC owner the tax maze is particularly complex and tough to navigate. 

Fortunately, this handy guide lays out all you need to know to jump through the hoops of LLC taxation and put your business on the path to success. 

LLC Taxation

LLCs are different from other types of business entities in that they can choose how to be taxed.  

By default, if your LLC has only one owner, or member, and you make no choice regarding taxation, your LLC is taxed as a sole proprietorship. This means that for tax purposes, the LLC is a disregarded entity and is not taxed. Profits and losses instead pass through to the member to be reported on their personal Schedule C tax return. 

If the LLC has more than one member, the default taxation is as a general partnership. The LLC is still not taxed, though it must file Form 1065, the U.S. Return of Partnership Income form, for informational purposes. Profits and losses pass through to the members based on their ownership percentages and gets reported on their personal tax returns.

Alternatively, LLC members can elect to have their business taxed as either an S-Corporation or a C-Corporation. This should only be done if they deem it financially beneficial to do so. 

If members choose to be taxed as a C-Corp, the LLC is taxed at the corporate income tax rate at the federal and state levels. LLC members pay taxes on dividends received and personal taxes on their salary.

If members choose S-Corp, the LLC itself is not taxed, but must file form 1120S, the U.S. Income Tax Return for an S-Corp form. Revenues again pass through to the owners, who must receive a “reasonable salary,” as defined by the IRS, before taking any profit distributions from the LLC. You’ll be responsible for employment taxes on that salary.

The main reason to choose S-Corp status is to avoid self-employment taxes. If your LLC is taxed as a sole proprietorship or partnership, members are responsible for self-employment taxes, which are discussed further below.

The IRS has several qualifications for S-Corp status eligibility. The company must:

• Be a domestic corporation
• Have only allowable shareholders
  • May be individuals, certain trusts, and estates and;
  • May not be partnerships, corporations or non-resident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

The decision on tax status is best made with the advice of a tax advisor. If you choose either of the corporation statuses, it’s a good idea to have your tax advisor handle your taxes, as they can get very complicated.

Franchise Taxes

Some states charge LLCs what’s called a franchise tax, known as a business privilege tax in some states. The tax is not a tax on franchise businesses but a tax on businesses for the right to do business in that state. California, for example, has an $800 annual tax all LLCs must pay.

Check with your state to learn about annual tax requirements and be sure to check due dates. Failing to pay those taxes can result in penalties or even the dissolution of your LLC.

Self-Employment Taxes

As mentioned above, members of an LLC taxed as a sole proprietorship or partnership are subject to self-employment taxes. 

Self-employment taxes go to Social Security and Medicare, which is what you would normally pay if you were an employee. The rate is 15.3%, of which 12.4% goes to Social Security and 2.9% to Medicare.

For 2022, income up to $147,000 is subject to the Social Security part of the tax. The Medicare part has no wage limit, but income over $200,000 is subject to an additional 0.9% Medicare tax.

Earnings subject to self-employment taxes are reported on Schedule SE. To learn more about self-employment taxes, visit the IRS website. 

Income Tax Withholdings and Payroll Taxes

If you have employees, you’re required to withhold income taxes and payroll taxes and pay employer-paid payroll taxes. Income tax is paid by the employee at the federal, state, and local levels. 

The amount withheld for federal income tax depends on the employee’s W-4, which specifies the employee’s filing status, dependents, and withholding requests. To calculate federal income tax withholdings, refer to IRS Publication 15. 

States and localities may require that employees fill out a state or local form similar to the W-4, which you can use to calculate those taxes, or they may have a flat amount that you’re required to withhold. 

Payroll taxes are taxes withheld from employee paychecks to fund Social Security and Medicare, similar to your self-employment taxes, and employers also make payroll tax contributions. These are known as FICA taxes, which stands for Federal Insurance Contributions Act. 

The Social Security tax is paid by the employee and the employer at 6.2% of the employee’s total compensation, and the Medicare tax is also paid by both, at a rate of 1.45% of employee compensation.

The same wage limits for self-employment taxes apply to FICA taxes. 

Employers are also required to pay taxes under the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA). The FUTA tax rate is 6% and has a taxable wage base of $7,000, while SUTA tax rates vary by state. 

To pay the federal income taxes withheld and FICA taxes, use Form 941, the Employer’s Quarterly Federal Tax Return. To pay FUTA taxes, use Form 940, the Employer’s Annual Federal Unemployment Tax Return. 

Check with your state and local governments for payment requirements for all state and local withheld taxes and payroll taxes.

Sales Tax

If your company sells taxable goods or services, you’ll need to obtain a sales tax permit in order to collect and pay sales taxes, if your state has a sales tax. Some localities also have sales taxes. Check with your state and local governments to learn all the details about sales taxes and required permits. 

In Closing

Welcome, once again, to the wild wild world of LLC taxes! 

If it seems a bit intimidating, that’s because it is, unfortunately. If you’re unsure how to proceed you may want to hire a tax advisor to handle everything, including payroll taxes. Alternatively, you could hire a payroll service to handle your payroll and payroll taxes for you.

If you decide to go it alone, just be sure to take the time to learn about all your tax requirements and deadlines and how to submit payments and make withholdings. Any serious error or late payment could result in major penalties, including even the closure of your business. 

Paying taxes is an absolute must to ensure the continued health of your LLC.