How can an LLC be taxed?

What is a Limited Liability Company (LLC)?

An LLC is a business where the owners are not personally liable for the debts and liabilities. The business structure of an LLC combines the limited liability protection of a corporation but with the flexible tax structure of a partnership or sole proprietorship.

An LLC is therefore regarded as a hybrid business entity with features of both corporations and partnerships. Many features of an LLC are like that of a corporation. The main difference is the flow-through taxation to the members of the LLC is a feature of a partnership as an option.  

When registering any business with your local secretary of state, there are several available LLC business structures, and it’s important to select the right one for you and your business. The available business structures include a Sole Proprietorship, Partnership, S-Corporation, and C-Corporation.

For many business owners, forming an LLC is the simplest way of structuring your business to protect personal assets. LLCs can be owned by one or even more people that are known as LLC members.

LLC Taxed as Sole Proprietorship

The advantage of an LLC over other entities is pass-through taxation. LLC’s are not required to pay taxes at the corporate level, the owners report the profit and losses on personal tax returns, and so they are not subject to double taxation.

How a one-member LLC pays income tax depends on how many members the LLC has in the business structure. If the LLC has one member, this is considered to be a sole proprietorship for tax purposes, but with several members would be regarded as a partnership. The default classification for a single-member LLC is to be taxed as a sole proprietorship.

A single-member LLC is not required to file its own tax return, the business’ profits and losses are reported by the business owner through the filing of IRS Form 1040. The Internal Revenue Service does not separate the LLC from the owner for federal income tax purposes, so the LLC is taxed the same way a sole proprietorship is taxed. 

One of the downsides of sole proprietorship taxation is that all of the LLC’s profits are considered self-employment income and thus subject to payroll taxes

In this case, the IRS treats the owner and the LLC as one. This applies only to single-member LLCs that the IRS refers to as a disregarded entity. The disregarded LLC is then taxed like a sole proprietorship, and the owner will report the LLC on either a Schedule C, Schedule E, or Schedule F.

The calculation of the income, expenses and net income are calculated through the Schedule C. The net income from the Schedule C calculation is then brought over to the owner’s personal tax return (Form 1040).

LLC Taxed as a General Partnership

An LLC business structure with more than one member pays income taxes as a general partnership rather than a proprietorship. However, the partnership does not pay the taxes straight to the IRS; the individual will pay tax based on the members’ share of ownership in the partnership.

To report income for an LLC member, you will need to follow several steps that include filing an information return with the IRS through Form 1065 (partnership return) and transfer your Schedule K-1 (record of your share of profit & loss) to a Schedule E (supplemental income). This process will need to be completed by each member of the LLC.

The final step would be to include the income from Schedule E in the correct place on IRS Form 1040.

LLC Taxed as an S-Corporation

LLC’s that are taxed as a corporation is subject to corporate tax rules. The business itself doesn’t get taxed. The LLC’s profits are passed on to the shareholders as it is considered a pass-through entity and taxed, in this case, pays income tax on the net earnings with the LLC members paying tax on dividends they receive.

As an S-Corporation, an LLC owner is not required to pay their own self-employment tax as the owners are not considered as self-employed. Most S-Corporation owners work for the business as employees and pay FICA (Federal Insurance Contributions Act) taxes on the income from their employment (Social Security/Medicare tax only).  

An owner of an LLC with the S-Corporation election must take a reasonable salary, and that salary is subject to the 15.3% self-employment tax. A tax benefit of being taxed as an S-corp is that any remaining profit after this will not be subject to any self-employment tax.

A business taxed as an LLC with an S-Corporation structure has the tax advantage of the owner being able to split their income from the S-Corporation between a distribution and an employee. The S-Corporation profits are distributed to the owners, and this tax status avoids double taxation

An S-Corporation owner has the option to take a 20% tax deduction from his or her share of the business income in addition to usual business expense deductions. 

An LLC needs to file IRS Form 2553 to receive S-Corporation status.  LLCs making this tax election are encouraged to document the election through an operating agreement.

LLC Taxed as a C-Corporation

LLC’s that are taxed as a C-Corporation are not that common and applying mainly to large businesses. To have an LLC taxed as a C-Corporation, it must file Form 8832, Entity Classification Election, to receive C-corporation tax treatment with the IRS.

The advantage of an LLC being taxed as a C-Corporation is the business owner will be able to split their income so they can leave profits in the business. The business owner of the LLC will be able to take a reasonable salary, and by splitting the income can then keep the remaining profits in the company. With this approach, the business owner can keep themselves in a lower tax bracket. 

The downside to an LLC being taxed as a C-Corporation would be double taxation. LLCs taxed as a Sole Proprietorship, Partnership and S-Corporation are a pass-through entity for tax purposes. An LLC taxed as a C-Corporation must file a return federally with the IRS, and the owners of the LLC must also file a return with the IRS individually. In this case, the owner will be taxed twice on a corporate and personal level.

What expenses can an LLC deduct?

An LLC, like other businesses, has an opportunity to write off expenses, which reduces the amount of taxes owed to the IRS.

For a business expense to be deductible, the expense must be ordinary and necessary. An ordinary expense would be an expense accepted in the trade of the business. A necessary expense would be an expense that is appropriate for your business.  

The number of deductions will vary dependant on the type of business and industry, but some of the most common LLC tax deductions include the following:

  • Rental Expense
  • Cost of Goods Sold
  • Insurance
  • Professional Expenses 
  • Charitable Expenses
  • Independent Contractors 
  • Meals & Entertainment

For a more detailed breakdown of LLC deductible expenses and how this might look for a business in your industry, check out the IRS Business Expense Publication.  

Some of the tax write-offs for LLCs are written off in full on a single year’s return; this usually relates to small business expenses. Others are written off in increments over several years and relate more to larger expenses. Both will need to follow the IRS approved method to be written off.  

Do you have to pay LLC taxes if you made no money?

If your LLC business has made no income, it is still important to understand your LLC tax filing status to know whether you are required to file federal tax returns. 

The LLC tax filing requirements will depend on how the LLC is taxed, whether that’s Sole Proprietorship, Partnership, S-Corporation, or C-Corporation. An LLC might be disregarded for tax purposes as an entity for Sole Proprietorship, for example, but then taxed if the LLC is regarded as a Partnership or Corporation.

Generally, LLC’s that are taxed as a Sole Proprietorship or Partnership will not be required to file a federal tax return. But it is important to note that it could be a costly error to change the LLC tax status to a corporation from a sole proprietorship/partnership if the business has made no money.

It is recommended to check LLC tax requirements in your local state and at the IRS federal level to help avoid unnecessary fines and penalties.