Tax Accounting for Limited Liability Companies
Limited liability company taxation can seem bafflingly complex to new llc owners. But you need to understand just a couple of things in order to make sense of LLC taxation: (1) The default tax accounting rules and (2) the elections that most LLCs can make to opt out of the default rules.
Note: A reminder before I start the discussion that follows: The owners of a limited liability company are called "members."
Default Tax Treatment of a Single-member LLC
By default, a single member LLC is disregarded. In other words, the one owner LLC gets ignored.
This sounds tricky, but the "disregarding" just means that the income or deductions of the LLC go on the owner's regular tax return. For example, if an individual owns an LLC that operates an active trade or business, the LLC's income and deductions go on the "Schedule C Profit or Loss From Sole Proprietorship" page of the person's tax return.
And if an individual owns an LLC that holds rental property, the LLC's income and deductions go on the "Schedule E Supplemental Income and Loss" page of the person's tax return.
In other words, the fact that the business or real estate is operated or owned by an LLC is sort of irrelevant for tax accounting. The LLC is, in the language of tax law, disregarded.
By the way, the tax accounting works similarly if the owner of the LLC is a corporation or partnership. If the owner is a corporation or partnership, the LLC's income and deductions just get combined with the corporation's or partnership's other income and deductions and appears on the corporation's or partnership's tax return.
And another interesting little wrinkle here: An llc owned by a husband and wife who reside in a community property state can be treated a as a single-member, or one owner, llc, meaning that such an llc can also be disregarded.
Default Tax Treatment of a Multiple-member LLC
A multiple member llc by default is treated as a partnership. This means that the LLC's income and deductions get reported on a partnership tax return. And then that tax return allocates the income and deductions among the partners, or LLC members.
Each partner, or LLC member, receives a K-1 from the partnership. The K-1 shows that partner's share of the income and deductions flowing out of the partnership.
Electing Out of Default LLC Tax Treatment
Many people would find LLC taxation pretty easy if only the default rules were used… However, you don't have to use the default tax treatment for an LLC. You can elect to opt out of the default tax treatment. In other words, single and multiple member LLCs don't have to accept the default tax accounting treatment--they can instead choose to be taxed as corporations.
If an LLC elects to be taxed as a corporation, the LLC is still an LLC. (This is confusing, I know.) But the LLC for income tax purposes is treated as a corporation. For tax accounting purposes, for example, a single member LLC is either disregarded… or treated as a corporation. And a multiple member LLC is either treated as a partnership… or treated as a corporation.
Note: Getting treated as a corporation occurs only after the LLC and its owner proactively elect to be treated as a corporation using either the 8832 or the 2553 form (both available from the www.irs.gov website).
S Corporation vs. C Corporation
Because the preceding paragraphs broach the subject of corporations and corporate taxation, let me mention that there are actually two sets of rules for how the tax accounting works for a corporation. The usual set of rules appear in a chunk of the tax law called "Subchapter C." Large publicly-held corporations and many other smaller corporations use the Subchapter C rules.
Many small corporations and many small LLCs electing to be taxed as corporations, however, use an alternative set of tax accounting rules that come out of another chunk of the tax law called "Subchapter S." If you've talked to many experienced small business owners, you'll have undoubtedly heard them talk about Subchapter S. Businesses that use the Subchapter S rules, often called S corporations, pay no corporate income tax and often save their owners lots of self-employment tax.
Note: I provide tons of information about S corporations and S corporation taxation at a sister web site, www.scorporationsexplained.com. If you're thinking about making an election to opt out of the default tax treatment for an LLC, you can review that site's information. You may also want to read the FAQ article at the site you're already at, www.llcsexplained.com, that discusses how S corporations save taxes:
Tax Effects of Incorporating an LLC
Normally, you don't need to worry very much about the tax effects of forming an LLC. By default, an LLC is either a disregarded entity or a partnership. And forming a disregarded entity (like a sole proprietorship) or a partnership should only rarely in and of itself trigger taxes.
Furthermore, if you form an LLC, immediately elect C corporation status or S corporation status, and then begin doing business, the formation of the LLC and then the subsequent election should also not trigger any taxes.
However, if you're forming an LLC and planning to subsequently elect corporation tax treatment for an exsting business or investment you need to be more careful. In some situations--specifically, when you transfer personal debts to the LLC and then elect corporation tax treatment or when you transfer more liabilities than the book value of the assets you transfer--you can inadvertently trigger taxes by "incorporating" the LLC. For more information about how, why and when this taxation occurs, you can read this article:
http://www.scorporationsexplained.com/incorporate-an-existing-business.htm
By the way, if after reading the above article you don't feel like you understand the issues of incorporating an existing business with debt, you may not want to use do-it-yourself LLC formation kits (like we sell at this website) or online incorporation services (including our overnight $199 incorporation service). Instead, you may want to work with a local attorney or tax accountant who can review the specifics of your situation. In this setting, you are not really "upgrading" to a local professional for the work of preparing the documents... the paperwork is pretty straightforward. Rather, what you're "upgrading" for is the opportunity get some tax planning help.
Note: If you have a question about one of our do-it-yourself LLC kits, click on the Choose State button at the top of the page. Further, if you have questions about our overnight document preparation service, click on the Order button at the top of the page.
llc owners subject to payroll taxes
And now let me also just briefly address a related point. People often wonder about the LLC members and self employment taxes, 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 15.3% 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 calculate 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 LLC's 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.
Getting a CPA's help with an LLC income tax return:
If you're operating a single-member LLC that's 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 $700 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.