The limited liability company (LLC) is one of the most popular business entities in America, and one of the biggest reasons for that popularity is the more reasonable tax burden of the LLC compared to the corporation.
In fact, LLC owners are allowed to choose from several different tax models, in order to find the best possible form of taxation for your business. But how exactly is an LLC taxed, and what are your options in this regard?
We decided to write this article because we get so many questions from our readers about the tax responsibilities of an LLC owner.
With this in mind, this guide includes information about your options for LLC taxation, along with an explanation of why entrepreneurs enjoy the LLC’s tax structures. How will the LLC’s tax obligations affect your business? Let’s find out!
What Is an LLC?
Before we get too far into the details, let’s quickly address some of the basics. The limited liability company is a business owned and operated by one or more people, who are often referred to as “members” of the LLC.
The LLC – easy to form yourself or through an LLC website like LegalZoom – is a hybrid business structure that combines the casual flexibility of sole proprietorships and general partnerships with the limited liability protection of a corporation.
One of the main reasons for the LLC’s popularity is because it provides personal asset protection, which means that creditors can only pursue your business assets in a lawsuit against your company, while your car, house, and personal bank accounts remain protected.
In addition, many entrepreneurs save a considerable amount of money on taxes thanks to the LLC’s “pass-through” taxation.
How Is an LLC Taxed?
There are three main options for LLC taxation, although one of them is far more popular than the other two. Let’s start with the most common taxation structure, then work our way through the less popular options in this regard.
The default tax structure for a limited liability company is nearly identical to that of the general partnership. As a pass-through entity, there are no corporate-level taxes paid by an LLC. Instead, the business profits and losses pass through the company to its owners, who pay taxes on this money on the individual level.
There is no business tax return for an LLC that chooses this type of tax structure, which helps this entity avoid the “double taxation” that applies to many corporations (more on this in a moment).
For a single-member LLC, the only requirement is that the owner needs to claim their net business income using the Schedule C form from the Internal Revenue Service, and also include this information on an IRS Form 1040 for their personal tax return.
If you operate a multi-member LLC, you will need to file an informational report with the IRS. This is known as the Form 1065, and it tells the IRS how much your company’s overall tax burden is. This way, the government knows exactly how much money it can expect from each member of your LLC’s ownership group.
C Corporation-Style Taxation
Another option for LLCs is the C corporation taxation model. The majority of corporations are classified as C corps, partially because it’s the default option, and also because there are far fewer rules and regulations governing the C corp than the S corp.
The C corporation pays taxes at both the corporate level and at the individual level, which is often referred to as “double taxation.” With this model, your business income is taxed 21% at the corporate level, and then you also pay taxes on that same income again on your individual return.
The only situation where electing to be taxed as a C corp makes sense is if your owners are high-income individuals. Because the upper echelon of individual tax rates is higher than any corporate tax rate, it could make sense to elect C corp taxation for your LLC if you want to keep some of your business income invested in your company.
In this way, you don’t have to claim all of your business profits for the year, because you didn’t take all of that money in a distribution.
S Corporation-Style Taxation
Limited liability companies can also elect to be taxed as S corporations. The basic tenets of S corp taxation are nearly identical to the LLC and the partnership, in that the business income passes through the business structure itself, and the owners claim that income on their own personal taxes.
The difference between default LLC taxation and S corp taxation is the fact that with the S corporation structure, LLC owners can be categorized as employees of their own companies, whereas that is not an option with the partnership-style route. In some ways, this makes no difference whatsoever, especially in regard to self-employment tax.
Under the standard LLC taxation method, owners are not considered to be employees, and therefore are subject to self-employment tax. This tax rate is a total of 15.3% ― the combined employee and employer share of both Medicare and Social Security ― and it is paid in addition to income tax.
However, even though S corp owners can be employees in a legal sense, it doesn’t really matter for self-employment tax purposes, because even if they’re only paying the employee share on their personal tax return, they’re also still responsible for the employer share as an owner of the LLC.
The major advantage of S corporation taxation in this regard is the fact that you don’t need to pay employment taxes on S corp distributions. Due to this rule, you can save a considerable amount of money on Social Security and Medicare tax, because you only have to pay these taxes on your income as an employee, while the rest can pass through your business to you as an individual as a distribution. The amount that you choose to distribute is then not taxed for Social Security or Medicare purposes.
However, your limited liability company must meet several guidelines in order to be taxed as an S corporation. First off, your LLC cannot have more than 100 owners, and all of your owners must be citizens or residents of the United States. Your LLC also can only have individuals as owners, which means no other business entities can own part of your limited liability company if you want to elect the S corporation taxation model.
Other Important Facts About LLC Taxation
Splitting Up the Tax Burden
There are quite a few options for the limited liability company when it comes to taxation, and one of them is how it chooses to divide the total tax burden. Usually, the owners of a multi-member LLC will split the tax responsibilities (and the net income) evenly, but this is certainly not the only option.
For example, if you have certain members that are more or less involved in the company’s daily operations, or if they contributed uneven amounts of money to the LLC, you can divide the tax burden unevenly.
Paying Estimated Taxes
Because of the self-employment status of limited liability company owners, there is no employer withholding tax money from your income.
Therefore, the IRS requires that each owner of an LLC pay estimated taxes each quarter. The IRS says that you’re supposed to pay a minimum of 90% of your annual tax obligations via the estimated tax program, and you could be subject to a fine if you fail to meet this threshold.
Acquiring an EIN
The vast majority of limited liability companies need to obtain a federal tax ID number, or EIN (employer identification number). This is an absolute must if you have employees, and you’ll typically need one to open a business bank account as well.
All you need to do to acquire an EIN is to complete the IRS EIN Assistant application. There is no cost to get an EIN, and it doesn’t take long to fill out the application either.
Foreign Nationals Need a TIN
Limited liability companies are allowed to have owners that aren’t residents or citizens of the United States.
If your ownership group includes any non-resident, non-citizen members, they will need to acquire a taxpayer identification number, or TIN. Without a TIN, those owners will not be able to pay their taxes. To get a TIN, you can complete IRS Form W-7.
The “Tax Haven” Myth
There are plenty of websites out there that will tell you that you can save money on your limited liability company taxes by forming your business in a “tax haven” state like Nevada or Wyoming.
We’re here to tell you that this is very rarely the case, and you can actually end up spending more money if you form your LLC anywhere other than your own home state.
The truth is, you’re responsible for taxes on all business transactions executed in your state, and forming your LLC elsewhere doesn’t change that.
For example, if your business is located in Pennsylvania, and that’s where you transact most of your business, it doesn’t matter if you form your business in Wyoming ― you will still need to pay Pennsylvania taxes on your business transactions in that state.
In addition, you could actually rack up quite a few extra expenses if you form your business in a state you don’t operate in, because there will be additional compliance requirements. There will also likely be extra startup and maintenance costs, due to the fact that you’ll need to register a foreign LLC in order to operate in compliant fashion.
In short, don’t believe the hype about tax haven states. In most cases, you’re better off simply forming your LLC in your home state.
In general, taxes for limited liability companies aren’t all that complicated. For the vast majority of LLCs, all you need to do is stick with the default partnership-style tax structure, and follow some simple guidelines along the way.
Much of the additional material in this guide doesn’t apply to most LLCs, but we felt it was best to present you with all the relevant information so that you can make the right decision for your business.
We hope that this guide helped you expand your knowledge of LLC tax regulations!