Like the owners of sole
proprietorships and partnerships, LLC owners report business
income and losses on their personal tax returns.
An LLC is not a separate tax entity
like a corporation; instead, it is what the IRS calls a
"pass-through entity," like a partnership or sole
proprietorship. All of the profits and losses of the LLC
"pass through" the business to the LLC owners (called
members), who report this information on their personal tax
returns. The LLC itself does not pay federal income taxes, but
some states do charge the LLC itself a tax.
Income Taxes
The IRS treats your LLC like a sole proprietorship or a
partnership, depending on the number of members in your LLC. If
you've already done business as a sole proprietorship or
partnership, you're ahead of the game because you know many of
the rules already. If not, here are the basics:
Single-Owner LLCs
The IRS treats one-member LLCs as sole proprietorships for tax
purposes. This means that the LLC itself does not pay taxes and
does not have to file a return with the IRS.
As the sole owner of your LLC, you must report all profits
(or losses) of the LLC on Schedule C, and submit it with your
1040 tax return. If you leave money in the company's bank
account at the end of the year -- for instance, to cover future
expenses or expand the business -- you must pay taxes on that
money.
Multi-Owner LLCs
The IRS treats co-owned LLCs as partnerships for tax purposes.
Co-owned LLCs themselves do not pay taxes on business income;
instead, the LLC owners each pay taxes on their lawful share of
the profits on their personal income tax returns (with Schedule
E attached). Each LLC member's share of profits and losses,
called a distributive share, is set out in the LLC operating
agreement.
Most operating agreements provide that a member's
distributive share is in proportion to his percentage interest
in the business. For instance, if Jimmy owns 60% of the LLC, and
Luana owns the other 40%, Jimmy will be entitled to 60% of the
LLC's profits and losses, and Luana will be entitled to 40%. If
you'd like to split up profits and losses in a way that is not
proportionate to the members' percentage interests in the
business, it's called a "special allocation," and you
must carefully follow IRS rules.
However the distributive shares are divvied up, the IRS
treats each LLC member as though she receives her entire
distributive share each year. This means that each LLC member
must pay taxes on her distributive share whether or not the LLC
actually distributes the money to her. The practical
significance of this IRS rule is that even if LLC members need
to leave profits in the LLC -- for instance, to buy inventory or
expand the business -- each LLC member is liable for income tax
on his rightful share of that money.
Even though a co-owned LLC itself does not pay income taxes, it
must file Form 1065 with the IRS. This form, the same one that a
partnership files, is an informational return that the IRS
reviews to make sure the LLC members are reporting their income
correctly. The LLC must also provide each LLC member with a
"Schedule K-1," which breaks down each member's share
of the LLC's profits and losses. In turn, each LLC member
reports this profit and loss information on his individual Form
1040, with Schedule E attached.
LLCs Can
Elect Corporate Taxation
If your LLC will regularly need
to retain a significant amount of profits in
the company, you (and your co-owners, if you
have any) can save money by electing to have
your LLC taxed as a corporation.
Estimating and Paying Income Taxes
Because LLC members are not considered employees of the LLC, but
rather self-employed business owners, they are not subject to
tax withholding. Instead, each LLC member is responsible for
setting aside enough money to pay taxes on his share of the
profits. You must estimate the amount of tax you'll owe for the
year and make payments to the IRS (and usually to the
appropriate state tax agency) each quarter -- in April, June,
September and January.
Self-Employment Taxes
Because, again, LLC members are not employees but self-employed
business owners, contributions to the Social Security and
Medicare systems (collectively called the
"self-employment" tax) are not withheld from their
paychecks. Instead, most LLC owners are required to pay the
self-employment tax directly to the IRS.
The current rule is that any owner who works in or helps
manage the business must pay this tax on her distributive share
--her rightful share of profits. However, owners who are not
active in the LLC -- that is, those who have merely invested
money but don't provide services or make management decisions
for the LLC -- may be exempt from paying self-employment taxes
on their share of profits. The regulations in this area are a
bit complicated, but if you actively manage or work in your LLC,
you can expect to pay the self-employment tax on all LLC profits
allocated to you.
Each owner who is subject to the self-employment tax reports
it on Schedule SE, which she submits annually with her 1040 tax
return. LLC owners pay twice as much self-employment tax as
regular employees, since regular employees' contributions to the
self-employment tax are matched by their employers. The current
self-employment tax rate for business owners is 15.3% of the
first $76,200 of income and 2.9% of everything over $76,200.
Expenses
and Deductions
As you no doubt already know,
you don't have to pay taxes --income taxes or
self-employment taxes -- on money that your
business spends in pursuit of profit. You can
deduct ("write off") your legitimate
business expenses from your business income,
which can greatly lower the profits you must
report to the IRS. Deductible expenses include
start-up costs, automobile, travel and
entertainment expenses and advertising and
promotion costs.
State Taxes and Fees
Most states tax LLC profits the same way the IRS does: The LLC
owners pay taxes to the state on their personal returns; the LLC
itself does not pay a state tax. A few states, however, do
charge the LLC a tax based on the amount of income the LLC
makes, in addition to the income tax its owners pay. For
instance, California levies a tax on LLCs that make over
$250,000 per year; the tax ranges from about $1,000 to $9,000.
In addition, some states (including California, Delaware,
Illinois, Massachusetts, New Hampshire, Pennsylvania and
Wyoming) impose an annual fee on LLCs, alternately called a
" franchise tax," an "annual registration
fee" or a "renewal fee." In most states, the fee
is about $100, but California exacts a hefty $800 fee per year
from LLCs, and Illinois, Massachusetts and Pennsylvania charge
$300, $500 and $330, respectively. Before forming an LLC, find
out if your state charges a separate LLC-level tax by visiting
the website of your state's Revenue or Tax Department, or by
giving them a call.
Can
Corporate Taxation Cut Your LLC Tax Bill?
If you regularly need to keep a
substantial amount of profits in your LLC
(called "retained earnings"), you
might benefit from electing corporate
taxation. Any LLC can be treated like a
corporation for tax purposes by filing IRS
Form 8832 and checking the corporate tax
treatment box on the form.
After making this election, profits kept in
the LLC are taxed at the separate income tax
rates that apply to corporations; the owners
don't pay personal income taxes on profits
left in the company. (Unlike an LLC, a
corporation pays its own taxes on all
corporate profits left in the business.)
Because the corporate income tax rates for the
first $75,000 of corporate taxable income are
lower than the individual income tax rates
that apply to most LLC owners, this can save
you and your co-owners money in overall taxes.
For example, if your retail outfit needs to
stock up on expensive inventory at the
beginning of each year, you might decide to
leave $50,000 in your business at year's end.
With the regular pass-through taxation of an
LLC, these retained profits would likely be
taxed at your individual tax rate, which is
probably 28% or 31%. But with corporate
taxation, that $50,000 is taxed at the lower
15% corporate rate.
Once you elect corporate taxation, however,
you can't switch back to pass-through taxation
for five years, and if you do switch back,
there could be negative tax consequences. In
ohter words, you should treat the decision to
elect corporate taxation as seriously as you
would the decision to convert your LLC to a
corporation.
Solutions
are dependent upon facts & circumstances, law and the
objectives. These elements vary from one time to another, from one
circumstance to another and from person or entity to another
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