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When starting a business, one of your options is to structure your company as an LLC or a Limited Liability Company. In this guide, we will walk you through what an LLC is. More importantly, what you have to expect when tax season comes around when it comes to LLC taxation.

What is an LLC?

what is LLC

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A limited liability company (LLC) is a type of privately-held company specific to the US. Variations of the LLC exist in other countries under different names like the UK’s private company limited by shares, France’s société à responsabilité limitée, and Germany’s GmbH. The key feature is the protection it offers to your assets in case someone sues your business. This type of security is afforded by combining the pass-through taxation of a partnership or sole proprietorship with the — as its name implies — limited liability of a corporation.

LLCs can be owned by one or more individuals that are referred to as “members.” An LLC with one owner is called a single-member LLC. Similarly, an LLC with two or more members is called a multi-member LLC.

Why Should I Form an LLC?

Structuring your business as an LLC has many advantages and only a few downsides, especially if you are a small business:

  • Unlike corporations, an LLC is simple to form and requires less paperwork. 
  • Compared with sole proprietorships and general partnerships, it can protect your personal assets if someone sues your business. As long as there is no fraudulent or criminal behavior reported, the members of the LLC are not personally liable for the LLC’s debts or lawsuits. 
  • Boosts your credibility to loan-giving bodies and customers
  • It prevents double taxation because it is a pass-through entity. 

What is Pass-Through Taxation? 

One of the highlights of an LLC is its status as a pass-through entity. An LLC’s profits go directly to its members, who can then declare their shares in their personal tax returns. This is called pass-through taxation. For comparison, a C corporation’s profits are taxed twice: first before you divide it among the owners, and second, after each owner reports their share on their individual tax returns. Hence, the term “double-taxation.”

Disadvantages of an LLC

An LLC’s status as a pass-through entity is a double-edged sword. While it’s great because it helps avoid double taxation, this same feature puts off some potential investors: LLCs are ignored mainly by corporations seeking to invest because it is a pass-through entity. 

Once a corporation becomes an owner or member of an LLC, they’d have no choice but to partake in its tax liabilities. You’d also have to pay its share of LLC tax whether or not the income was distributed to the members.

  • Other disadvantages of an LLC include:
  • Profits being subject to medicare and social security taxes.
  • LLC owners might end up owing more in taxes than corporation owners because both salaries and profits are taxable.
  • LLC owners must immediately report profits.
  • The fringer benefits of employees are to be taxed.

Don’t let the above reasons completely dissuade you from forming an LLC. These disadvantages can also be true for other types of business structures. For instance, employees of S corporations who own more than 2% of the company also have to report their fringe benefits as part of their taxable income.

How do you Tax an LLC?

An LLC is taxed like any of the four existing business types. There is no specific LLC taxation clas. So they will have to pay tax as either of the following:

  • Sole Proprietorship
  • Partnership
  • C-Corporation
  • S-Corporation

Because an LLC is a pass-through entity (meaning the profits pass directly to the owners), the LLC itself does not owe federal income taxes. Instead, the LLC owners are subject to taxation and must declare the profits and losses on their personal income tax returns.

The Default Tax Classification of an LLC

how to tax LLC

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By default, an LLC taxation is according to the number of members or owners. That is unless you request to do the IRS to do differently.

Single-members LLCs, or LLCs with only one owner, are taxed as a Sole Proprietorship. Multi-member LLCs (with 2 or more members) are taxed as a Partnership.

Most LLCs stick to their default classifications. However, another option exists if they wish to be taxed differently. They can elect themselves as an S-corporation or C-corporation. You have to file IRS Form 2553 for the former and Form 8832 for the latter).

The LLC as a Disregarded Entity

Another term important term you’ll come across as you learn how an LLC taxation is LLC Disregarded Entity. This term is used by the IRS and applies to LLCs that didn’t opt to be taxed as S-corp or C-corp. 

It simply indicates that an LLC is disregarded by the IRS as a separate entity. It instead sees the owner and the LLC as one when taxes are concerned. This doesn’t affect an LLC and its owner’s liability protection as they technically remain separate entities under this context.

A disregarded LLC owned by one person (single-member taxed as a Sole Proprietorship) will declare the LLC’s activities on either of the following: Schedule C, Schedule E, or Schedule F.

On the other hand, the activities of a single-member disregarded LLC owned by another company are declared on the owner’s personal tax return. These are later identified as a division of the current company.

Filing as a Sole Proprietorship or Partnership

As a single-member LLC,  you won’t have to file separate taxes. You will simply report the LLC’s profits and losses on your individual income tax return (Form 1040). You’ll only be taxed the profit at the rate dictated by your regular federal and state income tax brackets. 

The IRS categorizes Multi-owner LLCs as partnerships. Like single-member LLCs, you don’t have to pay business income tax. Instead, the LLC owners or members pay taxes individually (on their personal income tax returns (with Schedule E attached)) based on their share of the profits. The share of each member’s profits and losses is called a distributive share. It should also be defined in the LLC operating agreement. File Form 1065 with the IRS.

Although a multi-member LLC does not pay a separate tax, it needs to file Form 1065 with the IRS. A partnership files this form as an informational return for the IRS to review reviews to ascertain that the members report their income accurately. The LLC must also provide each member with a Schedule K-1, which details every member’s share of the profits and losses. 

Filing as an S-Corporation

An S-corporation is very similar to a partnership and you can consider it as a pass-through entity. Its profits pass through to the owners. And you declare the income and losses in the same way as a partnership. The S-corp shareholders are provided a Schedule K-1 listing their shares on the Form 1120S of the corporation. The shareholders will then file Schedule E with their personal tax returns (Form 1040) to report their share income or losses.

The difference lies in owners’ employment status. For instance, in a partnership,  the owners of an LLC are not seen as employees,  just business owners. However, in an S-corporation, the owners will also be employees of the corporation. This means must compensate themselves a salary which they will pay income tax on. This salary is typically based on the experience, responsibilities, and time invested by the business members.

After the disbursement, you can identify any LLC income as unearned income and, thus, are not subject to self-employment taxes. Electing to be taxed as an S-corporation can be beneficial to businesses that make a lot of income. Primarily so that the members can save on self-employment income tax.

Filing as a C-Corporation

Finally, the least popular LLC taxation option: filing as a C-corporation. One of the reasons an LLC might want to be taxed as a corporation is the tax reduction effected by the Tax Cuts and Jobs Act (TCJA). 

You must note, though, that C-corp members are subject to double taxation:  21% tax rate in federal income taxes, plus each owner will be taxed on the remaining money they withdraw from the business either as a salary or dividend.

Another reason some LLCs opt for C-Corporation taxation is income splitting. This allows the LLC members or owners to stay on a lower tax bracket by paying themselves a salary that they will be taxed on (similar in S-Corporations). 

You can leave the remaining profit within the company as unearned. However, you will need to keep a close eye on this amount to make sure you stay exempt from the Accumulated Earnings Tax.

If an LLC is going to elect as a C-Corporation, it will file Form 8832 and must work with a professional accounting service to keep better track of its taxes.