tax accounting for limited liability companies
Limited liability company taxation can seem bafflingly complex to new llc owners. But it turns out that, in a sense, LLC taxation is really just deceptively simple. But let me explain. In a nutshell, an llc formation creates an entity that can for tax purposes be almost anything you want it to be. For example, an llc with one owner can be treated for income tax purposes as a sole proprietorship. And in fact if you set up a one owner llc, by default the IRS assumes that you want the llc treated as a sole proprietorship. Or the one owner limited liability company can be treated as a C corporation or even as an S corporation.
Note: An llc owned by a husband and wife who reside in a community property state can be treated as a single-member, or one owner, llc, meaning that such an llc can also file as a sole proprietorship.
An llc with multiple owners can be treated as partnership--and partnership treatment is the default classification. Alternatively, the multiple owner llc can elect to be treated as a C corporation or an S corporation.
What all this means is that you can't really answer the question "how is my llc taxed?" You can only answer the question, "How is my llc treated for income tax purposes: as a sole proprietorship, partnership, C corporation, or S corporation?" Once you have the answer to this question, you treat your llc appropriately--in other words, as a sole proprietorship or as a partnership or as a C or S corporation.
By the way, much of the information provided in the do-it-yourself llc formation kits provided by this web site relates to deciding whether you should make the election to convert your llc into a C corporation or an S corporation. Converting an llc to a C corporation can sometimes save small businesses thousands or tens of thousands of dollars a year in state income taxes. Alternatively, converting an llc to an S corporation can sometimes save businesses thousands of dollars a year in limited liability partner self-employment tax or payroll tax.
Note that S corporations have some restrictions as to when they can be created from llcs and also some restrictions as to who can own them. The general rule is that S corporations can only be owned by US individual taxpayers (citizens and permanent residents) or other taxpayers that are really close to being US individual taxpayers (like testamentary trusts and bankruptcy estates).
llc owners subject to payroll taxes
And now let me also just briefly address a related point. People often wonder about the limited liability partner self employment tax issue. And for good reason, it turns out. Small business limited liability companies often make their llc owners subject to payroll taxes.
In fact, in many cases, llc owners pay as much in payroll and self-employment taxes as they pay in income taxes. Payroll taxes run roughly 15.5% on the first $100,000 of earned income and 2.9% thereafter!
Fortunately, the limited liability partner self employment tax treatment is usually pretty straightforward. As mentioned, a limited liability company is always treated as “something else” for tax purposes. What this “something else” is allows you to answer the question, “Are llc owners subject to payroll taxes?” Here are the basic rules:
Single-member llcs treated as disregarded entities: If a single-member llc (or one owner llc) engages in an active trade or business, the llc pays self-employment tax on its profit. Note that in this case the single member llc reports in business income on a Schedule C tax form and calculates its self-employment tax on a Schedule SE tax form. If a single-member llc doesn’t engage in an active trade or business—say the llc engages in a passive activity such as real estate investing—the llc doesn’t pay self-employment tax on its profit. Note that in this case, the single member llc reports its passive income on a Schedule E.
Multiple-member llcs treated as partnerships: If a multiple-member llc (or multiple owner llc) engages in an active trade or business, the llc owners, or partners, pay self-employment tax on their shares of the profit. Note that in this case the multiple member llc reports its business income on a separate 1065 partnership tax return and the individual partners calculates their self-employment tax bills on their shares of the partnership profit on Schedule SE tax forms which accompany their 1040 individual tax returns. If a multiple-member llc doesn’t engage in an active trade or business, however, then the llc owners don’t pay self-employment tax on their shares of the profit. And in this case, the llc owners report their shares of the partnership’s profit on their respective Schedule Es.
LLCs treated as C corporations: If an llc makes an election to be treated as a regular C corporation, the LLCs profits are not subject to self-employment tax. The profits are, however, subject to corporate income tax as reported on the LLC’s 1120 corporate tax return. Furthermore, if the corporate profits are distributed to llc owners in the form of dividends, the dividends are taxed again at the 15% qualifying dividend rate. Note that a LLC treated as a C corporation would pay payroll taxes (which are equivalent to self-employment taxes) on any wages paid to llc members working in the business.
LLCs treated as S corporations: If an llc makes an election to be treated as an S corporation, the LLC’s profits are subject neither to self-employment taxes nor to corporate income tax. The S corporation does need to file an 1120S tax return, however, and through this tax return the LLC’s owners get taxed on their respective shares of the corporation’s profit. Note that if an llc owner works in the business, the LLC-treated-as-an-S corporation must pay a reasonable wage to the llc owner. The LLC absolutely does owe payroll taxes on these wages.
One final suggestion: Choosing the right taxation for your llc corporation can make huge difference in the federal and state tax bill paid. Sometimes the default classification--either sole proprietorship for a one owner llc or partnership for a multiple owner llc--is best choice. Other times, a C or S corporation is best. Accordingly, you may want to confer with a knowledgeable tax practitioner concerning the tax classification for your llc corporation.
Getting a CPA's help with an LLC income tax return:
If you're operating a single-member LLC that's gets treated as a sole proprietorship or an LLC that owns rental properties, you can often do your tax return yourself. (All you need to do is add a Schedule C (for a business) or a Schedule E (for rental property) to your regular 1040 tax return. If you've elected to have an LLC treated as an S corporation or as a C corporation, you probably should have a knowledgeable tax practitioner (a CPA, an enrolled agent or an attorney) prepare your tax return. Note that my CPA firm specializes in preparing federal and state S corporation tax returns. Typically, the price equals $750 for an LLC that's elected S status and that has less than $250,000 in revenue and less than $250,000 in total assets. And the price equals $1,500 for an LLC that's elected S status but has $250,000 or more in revenue or total assets. Note that you can get more information about my S Corporation Tax Return Preparation at my S Corp Home web site.