Like the owners of sole proprietorships and partnerships, LLC owners report business income and losses on their personal tax returns.
An LLC is not a separate tax entity like a corporation; instead, it is what the IRS calls a "pass-through entity," like a partnership or sole proprietorship. All of the profits and losses of the LLC "pass through" the business to the LLC owners (called members), who report this information on their personal tax returns. The LLC itself does not pay federal income taxes, but some states impose an annual tax on LLCs.
The IRS treats your LLC like a sole proprietorship or a partnership, depending on the number of members in your LLC. If you've already done business as a sole proprietorship or partnership, you're ahead of the game because you know many of the rules already. If not, here are the basics:
The IRS treats one-member LLCs as sole proprietorships for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS.
As the sole owner of your LLC, you must report all profits (or losses) of the LLC on Schedule C and submit it with your 1040 tax return. Even if you leave profits in the company's bank account at the end of the year -- for instance, to cover future expenses or expand the business -- you must pay income tax on that money.
The IRS treats co-owned LLCs as partnerships for tax purposes. Like one-member LLCs, co-owned LLCs do not pay taxes on business income; instead, the LLC owners each pay taxes on their lawful share of the profits on their personal income tax returns (with Schedule E attached). Each LLC member's share of profits and losses, called a distributive share, should be set out in the LLC operating agreement.
Most operating agreements provide that a member's distributive share is in proportion to his or her percentage interest in the business. For instance, if Jimmy owns 60% of the LLC, and Luana owns the other 40%, Jimmy will be entitled to 60% of the LLC's profits and losses, and Luana will be entitled to 40%. If you'd like to split up profits and losses in a way that is not proportionate to the members' percentage interests in the business, it's called a "special allocation," and you must carefully follow IRS rules.
However members' distributive shares are divvied up, the IRS treats each LLC member as though the member receives his or her entire distributive share each year. This means that each LLC member must pay taxes on his or her whole distributive share, whether or not the LLC actually distributes all (or any of) the money to the members. The practical significance of this IRS rule is that, even if LLC members need to leave profits in the LLC -- for instance, to buy inventory or expand the business -- each LLC member is liable for income tax on the member's rightful share of that money.
Even though a co-owned LLC itself does not pay income taxes, it must file Form 1065 with the IRS. This form, the same one that a partnership files, is an informational return that the IRS reviews to make sure that LLC members are reporting their income correctly. The LLC must also provide each LLC member with a Schedule K-1, which breaks down each member's share of the LLC's profits and losses. In turn, each LLC member reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.
Estimating and Paying Income Taxes
Because LLC members considered self-employed business owners rather than employees of the LLC, they are not subject to tax withholding. Instead, each LLC member is responsible for setting aside enough money to pay taxes on that member's share of the profits. The members must estimate the amount of tax they'll owe for the year and make quarterly payments to the IRS (and to the appropriate state tax agency, if there is a state income tax) -- in April, June, September, and January.
Because LLC members are not employees, no contributions to the Social Security and Medicare systems are withheld from their paychecks. Instead, most LLC owners are required to pay these taxes -- called "self-employment taxes when paid by a business owner -- directly to the IRS.
The current rule is that any owner who works in or helps manage the business must pay this tax on his or her distributive share (rightful share of profits). However, owners who are not active in the LLC -- that is, those who have merely invested money but don't provide services or make management decisions for the LLC -- may be exempt from paying self-employment taxes on their share of profits. The regulations in this area are a bit complicated, but if you actively manage or work in your LLC, you can expect to pay the self-employment tax on all LLC profits allocated to you.
Each owner who is subject to the self-employment tax reports the amount due on Schedule SE, which must be submitted annually with his or her tax return. LLC owners (and sole proprietors and partners) pay twice as much self-employment tax as regular employees, because regular employees' contributions to the self-employment tax are matched by their employers.
State Taxes and Fees
Most states tax LLC profits the same way the IRS does: The LLC owners pay taxes to the state on their personal returns, while the LLC itself does not pay a state tax. A few states, however, do charge the LLC a tax based on the amount of income the LLC makes, in addition to the income tax its owners pay. For instance, California levies a tax on LLCs that make over $250,000 per year; the tax ranges from about $900 to $11,000.
In addition, some states impose an annual LLC fee that is not income-related. This may be called a "franchise tax," an "annual registration fee" or a "renewal fee." In most states, the fee is about $100, but California exacts a hefty $800 "minimum franchise tax" per year from LLCs. Before forming an LLC, find out whether your state charges a separate LLC tax or fee. For more information, check the website of your state's secretary of state, department of corporations, or department of revenue or tax
Always contact an accountant for tax advice