Limited liability corporations, or LLCs, are becoming increasingly popular as their business structure allows owners of the company to escape double taxation on income. Understanding how LLCs are taxed and what owners’ responsibilities are with regard to reporting income and paying taxes is important to determining whether this business structure is right for your company.
Limited liability corporations allow owners to avoid corporate taxes and have the earnings of their company taxed as personal income instead, much like how income in partnerships are taxed.
Limited liability corporations have been around since the late 1970s, and were first established in Wyoming. The concept, modeled after a German business structure, was challenged by the IRS, but in 1988 the IRS made a ruling that it would tax LLCs as partnerships. This opened the floodgates for more states to adopt LLC legislation, and by the late 90s nearly every state in the U.S. had passed LLC acts. In 2009, there were more than 1.3 million LLCs in the United States.
LLC profits are taxed to company owners as individual income, although LLCs can choose instead to have the income taxed as corporate income (few ever do). LLC owners are required to report the profits and losses of the LLC to the IRS each year and report their income from the LLC too. In addition to federal income tax, LLC owners may also be required to pay self-employment and state income taxes.
Another key benefit of limited liability corporations is that they reduce the owners’ personal liability for the business. This can keep business owners from losing personal assets if the business has heavy debt and fails or if a substantial judgement is levied against the business in a lawsuit.
If you’re the sole owner of your LLC, your income will be treated like that of the owner of a sole proprietorship. You’ll need to report your business’ profits and losses on IRS Schedule C, and submit that form along with your individual tax return.
If your LLC has two or more partners, you’ll need to file an informational return, much like partnerships have to do, as well as your individual income tax return.
All LLCs must submit a copy of Form 1065, which is used to report partnership income. They’ll also need to submit Schedule K-1, which details how profits and losses are divided up among LLC owners. Each member must receive a copy of Schedule K-1 before it is submitted to the IRS.
Much of the time, members of an LLC each have an equal share of the LLCs profit and losses, but one feature of the LLC is that it allows for unequal division of profits and losses if the owners chose. This structure may be used to reward a managing partner for his or her contribution to the business.
Using the information from Schedule K-1, owners of the LLC will report their income from the LLC on their personal income tax form by using Schedule E.
With regard to payment, members of an LLC will need to estimate their annual taxes and make payments each quarter. Failing to make quarterly payments could result in penalties.
Paying self-employment taxes
Although using an LLC business structure helps you avoid getting hit with income taxes twice, it doesn’t excuse you from payroll taxes. Members of an LLC who earn more than $400 in profit from the business over a year are required by law to make contributions to Social Security and Medicare. These deductions are determined by the self-employment tax.
The self-employment tax is 15.3 percent – 12.4 percent for Social Security and 2.9 percent for Medicare. Recent payroll tax holidays have reduced the Social Security tax somewhat, and as of this writing negotiations concerning an extension of the holiday are ongoing.
The Social Security portion of self-employment tax is capped at $106,800. This means that you only pay the 12.4 percent tax on your first $106,800 of earnings. The Medicare tax of 2.9 percent is levied on all income.
Typically, only partners who are actively engaged in the operation of the business pay self-employment taxes. Owners who merely invest in the business and are not active in its operation are exempt from self-employment taxes in most instances. This issue can be thorny with tax officials, so it is wise to seek the advice of a tax professional in determining whether you must pay self-employment taxes if you are a partner in a limited liability corporation.
If you must pay self-employment taxes, you can deduct half of them from your taxable income at the end of each year.
Paying state taxes
The federal government more or less treats LLCs as partnerships for taxation purposes, but each state has its own way of dealing with LLCs and their tax status. Most states have policies similar to the federal government, giving LLCs pass-through status on taxes similar to that of partnerships. Other states treat them as partnerships in some respects, but levy additional taxes on LLCs.
The majority of states collect income taxes from members of LLCs based upon their share of business profits, just like the IRS does. In most cases, sole owners of LLCs will have to file tax forms similar to those of sole proprietorship business owners, while LLCs with two or more owners will need to file tax forms similar to those of partnership business owners. Also, much like federal income taxes, state income taxes must be paid on a quarterly basis.
Some states also impose annual feeds and other taxes on LLCS, such as franchise taxes, surcharge taxes, annual fees, etc. The amount of these taxes can range anywhere from $10 to many thousands of dollars.
The best way to determine what taxes your LLC will need to pay in your state is to contact your state’s revenue department and inquire.
LLCs can be an extremely advantageous business structure because of the tax and liability advantages it grants owners. Understanding the tax advantages of an LLC can better help you decide if this is the right structure for your new business.