The process of paying taxes for a business entity varies depending on which type of business structure you operate — sole proprietorships are taxed differently than corporations, for example.
The limited liability company (LLC) is a somewhat unique entity type because it actually gives its owners some options regarding how they want the company to be taxed. Unfortunately, reading through tax laws can leave your head reeling.
To help you out, we’ve compiled the three tax categories you need to address while paying taxes as an LLC.
Guru Tip: Taxes across the board can feel overwhelming and intimidating. We highly recommend finding and working with a good Certified Public Accountant (CPA) to work with.
LLCs pay both federal and state income taxes on any profits the business makes, but one of the unique aspects of the LLC is how there’s a degree of flexibility regarding how the business is taxed. They can choose to pay taxes as a pass-through entity, or they may select to be taxed as a corporation.
This choice affects how much tax is paid, as well as who pays it.
Taxation as a pass-through entity
Pass-through status applies to both single- and multi-member LLCs. As a pass-through entity, the LLC’s members report income from the LLC’s distributions on their personal tax returns.
This form of taxation is very similar to the one used by general partnerships — the business itself does not pay taxes, but rather the profits and/or losses “pass through” the entity to its owners, who then pay those taxes on their personal returns. With this tax process, the LLC’s income is taxed at the personal income tax rate.
Even though the LLC does not pay any corporate taxes under this taxation model, the business should file IRS Form 1065 as a report of the business income. This form helps ensure consistency between what the business reports and what each member reports.
How much profit each member gets from the LLC is dictated by the operating agreement. Then, at tax time, each member reports that income on Schedule C of their individual tax return (IRS Form 1040).
For state income taxes, the LLC’s members complete the same process using the appropriate form for their state. You can usually find the forms you need on your state’s Department of Revenue website.
Taxation as a corporation
The default tax setting for an LLC is as a pass-through entity, but LLCs can also elect to be taxed like a corporation — most commonly as a C corporation.
With this approach, it is not the members who pay the tax, but rather the LLC itself. The business is taxed at the corporate income tax rate (currently 21%), and the owners also pay taxes at the individual level once the dividends are paid from the company itself. This is often referred to as double taxation, because in theory the same money is being taxed twice.
This form of taxation is not very popular for LLCs, because it usually results in a greater tax burden than pass-through taxation. However, if your LLC’s owners are wealthy people who occupy one of the top individual tax brackets, the C corp tax model could actually save you some money.
Another option is to be taxed like an S corporation. This is quite similar to the default pass-through model used by general partnerships, but the difference is that the LLC’s owners can be classified as employees, which is not an option with the default model. This means that the owners can typically avoid paying self-employment tax, which we’ll discuss in-depth in a moment.
In short, S corp taxation does not require LLC owners to pay the employer’s share of Social Security and Medicare, which is required with partnership-style taxation. The issue with the S corp model is that there are some rather stringent requirements to adopt this model. For instance, your business can’t have more than 100 owners, all of them must be American citizens or residents, and no other business entities may claim any share of the company’s ownership.
You can find more information on electing corporate taxation on the IRS website.
Just like individuals can deduct certain expenses from their taxable income, businesses have some expenses which are tax-deductible, which allows you to lower your taxable income somewhat. The IRS says that deductible costs include any business expenses which are “ordinary and necessary.”
This applies to expenses such as business improvements, the cost of the goods you sell, buying new equipment, and more. You can find more information with the IRS resource on deducting business expenses.
The next form of taxation to consider as an LLC is self-employment tax, which includes the Social Security and Medicare taxes that every individual must pay.
In a traditional employer/employee relationship, these taxes are paid through withholdings from the employee’s paycheck. However, the members of an LLC are considered self-employed, and they don’t receive a paycheck.
Self-employment tax can get quite expensive, because each owner of the LLC is responsible for both the employer and employee portions of Social Security and Medicare. The total tax rate comes to 15.3%, which is required in addition to the income taxes of each owner.
You can read more about self-employment taxes here.
Additional State-Specific Taxes
In addition to any applicable federal taxes, some states require specific business taxes, such as a business franchise tax. For example, California is notorious for having hefty taxes for LLCs.
Most states also require a sales tax on the sale of certain goods or services. As the business, you are responsible for sending the funds to the state. However, you can choose who pays the tax: you or your customer. Most businesses choose to include the tax as part of the purchase price, so the customer actually pays it.
There are also other industry-specific taxes required. These can include taxes on oil, cigarettes, and alcohol, just to name a few. You should consult your state’s Department of Revenue for more information on business taxes, sales taxes, and industry taxes.
LLCs have three tax categories to consider: income taxes, self-employment taxes, and state-specific taxes.
The most important thing to keep in mind is how the limited liability company provides its owners with some options regarding how they want to be taxed. Broadly speaking, most LLCs use the default partnership-style taxation, but the C corporation and S corporation options are available if you would rather use them.
Taxation is always a complicated and multi-faceted aspect of business ownership and we highly recommend working with a professional.