An LLC, or a Limited Liability Company, is a popular business structure for small business owners for a few good reasons: separation of the member’s personal assets from the assets of the business, personal liability protection, and avoiding double-taxation (income being taxed at both the corporate and personal levels).[1] An LLC also comes with some tax flexibility because it can be treated like any other business structure, depending on what you elect. Let’s explore the four options for how LLCs can be taxed.
LLC Taxed Like a Sole Proprietorship
If you are the single member of an LLC, the business will receive the default classification as being taxed like a sole proprietorship unless you elect for it to be taxed like a corporation. An LLC taxed like a sole proprietorship is a “disregarded entity” for income tax purposes. A disregarded entity means that the entity is not separate from its owner. For a one-person shop, this is likely the way to go until the LLC profits typically exceed $75,000 or so (several factors need to be considered to make this determination). The business’s activities will be reported on the owner’s individual income tax return along with additional forms such as Schedule C through Schedule E. The owner simply pays income tax on net earnings of the LLC, just like a sole proprietorship.[2]
The owner of a single-member LLC is also responsible for self-employment tax, which is currently 15.3% of net income, which is made up of Social Security taxes and Medicare taxes), in addition to paying state taxes to the appropriate state tax agency. So, why bother with registering as an LLC if you’re just going to be taxed as a sole proprietorship? Protecting your assets! The other benefit is that as the business grows, you are able to change the LLC’s tax classification when it becomes beneficial to do so.
Related: How should a husband and wife LLC file?
LLC Taxed Like a General Partnership
An LLC with two or more members (referred to as a multi-member LLC) will have the default classification to being taxed like a general partnership unless you elect for it to be taxed like a corporation. When an LLC is taxed like a partnership, the LLC’s activity is filed on a partnership tax return, Form 1065 (U.S. Return of Partnership Income) for the business, but each individual member of the LLC shows their share of income, credits, and deductions on Schedule K-1 of their personal tax returns, which is based on their share of ownership. [3] The LLC owners can also “split” the self-employment tax on their K-1s according to their pro-rata share. The self-employment tax rate is the same for a partnership as it is for a sole proprietorship.
While it’s not required by most states, it’s especially important to create an LLC operating agreement for multi-member LLCs to document each of the LLC member’s share of profits and losses, called a distributive share, to have written proof of this allocation.
LLC Taxed Like an S-Corporation
An S-corporation is actually a tax classification and not a type of business structure, so an LLC, sole proprietorship, and corporation could all elect to be taxed like an S-corp for federal income tax purposes. For an LLC to receive S-Corp tax treatment, you need to fill out IRS Form 2553 (Election by a Small Business Corporation) no more than two months and 15 days after the beginning of the tax year or from forming the LLC. There are some qualifications to meet, such as having 100 or fewer shareholders who are all U.S. citizens, which is the only restriction on the number of members an LLC can have. S Corporation status is referred to as “pass-through taxation,” so the LLC income and losses of the business are passed through to the owners and reported on their personal tax returns, and the business avoids double taxation.[1]
Besides avoiding double taxation, the major tax advantage of being taxed like an S-Corp is the tax savings on self-employment taxes. This is because the owners are receiving both salaries and distributions. All owners who perform services for the business must receive a “reasonable salary” as deemed by the Internal Revenue Service. Salaries are subject to payroll taxes (Social Security and Medicare taxes), so that is where the employment taxes get paid when taxed like an S-Corp.
Related: What is a reasonable salary for an S Corporation?
A distribution is the owner’s share of business profits which is not subject to tax, including payroll taxes. If you’re thinking you can fool the IRS by taking a very small salary and very large distribution, think again! There have been court cases about this issue, and the IRS will use expert witnesses to determine what a “reasonable salary” should be for each shareholder who provides services.[4] Since the distributions aren’t taxed, the S Corp needs to be taxed somewhere, right? Of course. As discussed earlier, an S-Corp is a pass-through classification, so the owners file Schedules K/K-1 on their personal taxes.
At the end of the year, an LLC taxed like an S corporation will file a separate tax return, IRS Form 1120.
LLC Taxed Like a C-Corporation
A Limited Liability Company can elect to be taxed like a C-Corp for federal tax purposes, following the same rules and corporate tax treatment as a corporation. The business is taxed at the entity level at corporate tax rates. Any distributions, called dividends for a corporation, are taxed at the shareholder level.[3] If a shareholder also works for the company, the salary is taxed.
It is rare for a small business LLC to be taxed as a C-Corp because the costs and complexities of this type of taxation are higher than those of other elections. One of the primary drawbacks for most small business owners is the effect of double taxation. When an LLC elects to be taxed like a C corporation, the LLC pays taxes on gross income on its corporate tax return and then distributes the share of the profits to the owner(s) as a distribution. The owner then pays income tax on the distributions, which is how the term of double taxation comes up.
Being taxed like a C-Corp is a good choice for companies that want to raise capital or go public because to be taxed as a C-Corp, however, most aren’t going to choose the LLC structure.
Now that we’ve discussed the various ways in which LLCs can be taxed let’s explore the deductions available to LLCs.
To elect the C Corporation tax election for an LLC, the LLC members will need to file IRS Form 8832, Entity Classification Election).
What Expenses Can an LLC Deduct?
Deductible expenses are costs that are both ordinary (common in your industry) and necessary (helpful and appropriate for your business activities), regardless of the business entity type. Legitimate business expenses also need to be separate from the cost of goods sold, capital expenses, and personal expenses. Costs of goods sold are used to calculate gross profit (as a reduction of sales), so they are generally not allowed to be counted again as business expenses. Capital expenses are those that are capitalized, which means they become part of your business and are considered to be assets. Examples of capital expenses are start-up costs and improvements. Personal expenses are those that are not used for business. There are cases in which costs are incurred for both business and personal, so you can deduct the percentage that is attributable to the business.
Other deductible business expenses include employees’ pay, retirement plans for you and your employees, rent expenses, interest, taxes, and insurance.[5]
What if the LLC Didn’t Make Money?
If the LLC did not make any business income for the year, the LLC members do not need to fill it with their personal income tax returns when taxed, like a sole proprietorship or a partnership. If the LLC is taxed like a C-Corp or S-Corp, it still needs to file a federal tax return even if there was no activity for the year.
Depending on the statein which the LLC is formed, a franchise tax may still be assessed.
Conclusion
Whether you are a one-person show or have hundreds of employees, there are several options for how your LLC can be taxed. Though they each have their benefits and drawbacks, the freedom to choose what works best for your business entity is what makes having an LLC a great option for your small business come tax season. Before deciding, be sure to get tax advice from a qualified tax advisor to find the best choice for you.
[1] https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
[4] David E. Watson vs. U.S., filed by the United States Court of Appeals for the Eighth Circuit, No. 11-1589, filed February 21st, 2012, https://ecf.ca8.uscourts.gov/opndir/12/02/111589P.pdf.
[5] https://www.irs.gov/businesses/small-businesses-self-employed/deducting-business-expenses
