If you’re starting a business and considering forming a limited liability company (LLC), it’s important to understand how LLCs are taxed. No business entity has tax considerations as complex as those of an LLC, which offers a variety of potential advantages.
This handy guide will find all the information you need about LLC taxes and which option might be best for your business.
How LLCs Are Taxed
LLCs are pass-through entities, which means income passes through the company to the owners or members. If the LLC has only one member, it’s taxed as a sole proprietorship.
If the LLC has more than one member, it’s taxed as a partnership. Either way, passed-through income is reported on members’ tax returns.
But LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. You can choose to be taxed as a C-Corp or an S-Corp.
C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But keep in mind that C-Corp shareholders – who are members in the case of an LLC – must also pay taxes on their distributions. This is called double taxation.
However, members are subject to self-employment tax in an LLC that is taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status. With S-Corp status, the LLC remains a pass-through entity not subject to corporate taxes.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses.
How LLC Members are Paid
How you get paid as an LLC member depends on your chosen tax status.
If the LLC is taxed as a Sole Proprietorship or Partnership
If you’re the only member of an LLC and choose the default tax status, you can receive all the profits. If the company makes $50,000, for instance, you can receive $50,000.
You can receive distributions all at once or take them at intervals. Then, you write a check from the business bank account to pay your distributions. You’ll record the withdrawal for accounting purposes as an owner’s draw.
You will report all profit on Schedule C of your personal tax return, not just your draws. You’ll also be required to pay self-employment taxes on the profit.
In a multi-member LLC taxed as a partnership, members of the LLC can also take distributions from the profits. Distribution amounts are usually based on each member’s ownership percentage. For example, if two members own 50% and the business makes $50,000, each member draws $25,000.
A multi-member LLC taxed as a partnership must file form 1065 with the IRS, which is the Return of Partnership Income. Attached will be K-1 forms for each member showing their share of the business profits. Form 1065 is for reporting purposes only, as the LLC does not pay taxes.
Each member pays taxes on their share of profit based on Schedule C of their tax return and self-employment taxes on the profits.
If the LLC Is Taxed as an S-Corp or a C-Corp
If you are taxed as a corporation, you cannot be paid in distributions from your LLC. Instead, you must be paid as an employee of the LLC.
You must have an active role in the LLC to be an employee, so you must be involved in business operations to receive a salary or be an employee. In addition, if your LLC has more than one member and all members are active in the business, all members must receive a salary.
To become an employee, you’ll file a W-4 form. Then you can pay yourself a salary and receive a W-2 for tax purposes. Income tax and payroll taxes must be withheld from your salary checks.
The wages you’re paid will be an expense of the LLC, deducted from profits for accounting purposes. IRS rules state that salaries must be within your role’s industry norms.
If there are profits left after your salary, you can take part of the LLC profits as a shareholder distribution if you have S Corp status or a dividend if you have C Corp status.
One of the main benefits of an LLC is tax status flexibility. Most startups initially choose the default pass-through taxation, then might shift to a corporate tax status after a certain level of growth.
When choosing your tax status, be sure to get the advice of your tax advisor. They can help you determine the most financially beneficial status for you and your business.