How an LLC is taxed and what your options are
6 min read
April 07, 2022 • Block Advisors
Considering setting up your business as a limited liability company (LLC)? Perhaps your business is growing and becoming more complex. Maybe you wish to manage your exposure to risk as a business owner. Or possibly, you are eyeing the potential tax benefits that come along with this entity type.
As you weigh the pros and cons, you may have questions. How is an LLC taxed? How do LLC taxes work? What are the tax benefits of an LLC? We can help you find the answers.
An LLC is a business entity registered under state law to offer limited liability protection for its owners or “members.” Your business may be a single-member LLC if you are running the company on your own. Or it can be a multi-member LLC if you have business partners.
However, an LLC is not an IRS-recognized business structure for federal taxes. Rather, with an LLC, you get to choose how you’ll be taxed. Read on and we’ll explain.
How do LLC taxes work?
As an LLC, you could have up to four options for how to pay federal taxes. Your company may be eligible to be taxed as a sole proprietorship, a partnership, a C-corporation, or an S-corporation.
- Sole proprietorship. By default, the internal revenue code taxes a single-member LLC as a sole proprietorship. You may see it formally referred to on tax forms as a “disregarded entity.” This label means the LLC does not pay taxes separately from its owner. Instead, the business income and expenses from the company pass through the LLC to the business owner. The IRS “disregards” the entity for tax purposes. The single member files taxes on the amount earned each year. Individuals use Schedule C, which is part of the individual tax return Form 1040.
- Partnership. By default, the IRS taxes a multi-member LLC as a partnership. Like the sole proprietorship, LLC partnership taxes pass through the entity to the business owners. You’ll file Form 1065 with the IRS on behalf of the LLC annually by March 15. Then, a Schedule K-1 is issued to each member so that the members can report their portions of the annual profits and losses from the business on their own individual income tax returns.
Here’s where the choice comes in. Your single-member or multi-member LLC can proactively elect to be taxed as a C- or S-corporation. Choosing either status won’t affect your LLC as a business entity. You’ll continue to operate as an LLC, but the way your income is taxed will change.
- C-corporation. To choose this status, file a Form 8832 for a C-corporation (then file Form 1120 annually). If you file as a C-corp, the company’s net income will be taxed twice – first at the corporate level and then again (albeit at a favorable rate) when the after-tax profits are distributed to shareholders as dividends. This is known as “double taxation.” For more about C-corps see our post on LLC vs. C-corps.
- S-corporation. To choose this status, file a Form 2553 for an S-corporation if your business is eligible (then file Form 1120-S annually). If you elect to follow this path, your organization becomes a pass-through entity as described below, effectively avoiding “double taxation”. The important thing to know is that taxes on income from an S-corp are assessed at the owners’ individual rates. For more about S-corps see our post on LLC vs. S-corps.
Need help making your tax election decision? You don’t have to go it alone. A trusted Block Advisors small business certified tax pro can prepare your taxes and help you decide which tax option is right for your LLC.
What are the tax benefits of an LLC and what are the drawbacks?
Choosing a particular tax entity is a result of looking at several different factors, one of which is tax treatment. As a member of an LLC, you can take advantage of the following tax benefits:
- Pass-through income. When using a sole proprietorship, partnership, or even an S-corporation tax option, the LLC becomes a pass-through business entity. As such, profits and losses are passed directly to the members without the business entity paying federal taxes on the amount. Many LLC members view this benefit as a clear advantage over the double taxation method required for a C-corporation. As mentioned above, due to double taxation, C-corp profits are effectively taxed twice. First on a company level, then again when the LLC owner pays taxes on the dividends.
- Flexibility. With an LLC, you can choose how the business is taxed, whether that be as a sole proprietorship, partnership, or corporation. The default rules for sole proprietorship and partnership don’t require the filing of additional forms to make this choice. However, electing the corporation option does require an additional filing. Furthermore, it is important to understand that if you choose to change your classification after forming your LLC and selecting your initial classification, you will be locked-in to your new choice for the next 60 months.
- Corporate tax without the corporation. An LLC allows a business to be taxed as a corporation without forming one. LLCs are generally less expensive to operate, may involve less paperwork, have fewer formalities, and have lower administrative burdens than a corporation formed under state law.
Every business entity has pros and cons, and a smart business owner will weigh the good and the bad. A few of the tax drawbacks for LLCs are:
- Self-employment tax. LLC members taxed as a sole proprietor or partner must pay self-employment taxes. You’ll pay both the employer and the employee portions of self-employment tax using Schedule SE when filing Form 1040.
- Estimated tax payments. LLC members taxed as sole proprietorships or partnerships are typically required to make timely estimated tax payments. Once every quarter, you’ll make an estimated tax payment based on what you may owe at the end of the year in federal taxes. LLC members may need to make estimated tax payments at the state level as well.
- Tax limits on deductions. As an LLC member, you may have some tax limits on what you can deduct on your federal tax return. For example, in an LLC taxed as a partnership, an LLC member’s losses for the year may be limited to their adjusted tax basis for their membership interest at the end of the tax year.
To illustrate, consider Thomas’ home improvement company. Last year the business recorded a net loss of $10,000. Thomas holds a 30% membership interest in the LLC. So, his share of the loss is $3,000 ($10,000 x 0.30). If Thomas had a basis of $2,000 in his LLC interest, his deductible loss would be limited to $2,000.
Want more help with LLC tax questions?
While we’ve covered how an LLC is taxed and how LLC tax options work, you may still have questions about what’s right for your small business. Block Advisors small business certified tax pros can help.
Our tax pros have the expertise to walk you through the tax implications specific to your business during your tax appointment.