The term Limited Liability Company (LLC) may come up in conversation from time to time as a business owner. As online sales portal Shopify informs us, an LLC is a business structure that gives the protection of a corporate system while offering pass-through taxation to its members. It may not be immediately evident what "pass-through" taxation entails. According to Cornell Law School, pass-through taxation simply refers to the fact that the taxes aren't paid by the business but by a member or members of the company. Pass-through entities are like sole proprietorships or partnerships, in that sense. The owners and operators of these business structures pay taxes on the business earnings out of their own income from the company.
Income Taxes from LLCs
Since we already know that the IRS sees these businesses as pass-through entities, the question may arise about how they pay income tax. Are the members considered the ones to pay income tax? How does taxation work in companies that have more than one member?
Single Member LLCs and Income Tax
The IRS sees the single-member LLC as a disregarded entity. In non-specialist terms, the business and the owner are seen as a single entity for taxation purposes. Because the IRS considers both of these as the same, the taxes levied mirror a sole proprietorship. This method of taxation works by using a prepared Schedule C form. the form contains all the information about the business's income and expenses over the taxable period. Once the Schedule C is ready, the revenue is brought over to the owner's personal taxable income, and taxes are calculated based on this combined figure.
Multiple Member LLCs and Taxes
Most registered LLC are multi-member arrangements, and the taxes are slightly different in this case as well. Any LLC with more than one member pays taxes as if they were engaged in a partnership. The company itself (the LLC) doesn't pay any taxes to the IRS directly. Each partner pays taxes based on the percentage of the income they get from the registered company. As a member of an LLC, you are required to follow several steps to report your income:
- File an information return using IRS form 1065
- Collect a Schedule K-1, which shows each members percentage of earnings from the partnership
- Copy over the Schedule K-1to your Supplementary Income under Schedule E in your tax return
- Make reference to your Schedule E and ensure it's included in your filing documents
In this structure, the business's income filters through (pass-through, as noted above) to the individual members, and those members are then taxed individually. It should be noted that in some jurisdictions, members may also need to pay self-employment tax.
Electing For Corporate Taxation
An LLC is a flexible business structure, and one of the flexible portions of the business structure is electing for corporate taxation. If a significant portion of the business's earnings will be kept inside the company, then electing for corporate taxation might be a more viable method of approaching the tax problem. An LLC may agree to be treated as a corporation for tax purposes. All they would need to do is file IRS Form 8832 and select the box for "corporate tax treatment."
In 2018, the IRS declared that all C-Corps are taxed at a rate of 21%on all their profits. This rate is lower than the upper tier of personal income tax (32% - 37%). If an LLC owner has income coming in at that rate, they will earn more money having their taxes taken out from the LLC itself. However, it's a tricky business trying to game the system like this. C Corporations are taxed twice, once at the business level and again at the individual level. The capital gains tax rate of 23.8% is still less than the individual tax rate, but it may lead to a lower income from the business's revenue. If the company retains earnings, however, those aren't subject to double taxation. Additionally, registering to be taxed as a corporation allows businesses to offer employees and owners benefits such as stock options exempt from taxation.
Tax Deductions for Small Businesses
Generally speaking, a business can write-off or "deduct" business expenses from its income. This deduction results in paying fewer taxes. However, the deductions that the company makes should fall under the "ordinary and necessary" stipulation. Among the most evident of these expenses are:
- Health Benefits
- Equipment and Operating Expenses
- Travel Expenses
- Startup Costs
- Advertising and Promotion
In addition to these deductions, as of 2018, businesses may also qualify for new tax exemptions under the Tax Cuts and Jobs Act. An LLC owner can potentially deduct up to 20% of their net income from taxation calculation. There are stipulations for this deduction, including:
- The taxable income must remain below a specific critical limit. If it passes this limit, the deduction changes to 50%of what is paid to employees
- This deduction doesn't apply to certain service-based industries
Other LLC Taxes
In addition to standard income tax, LLC members also need to pay state and self-employment taxes. Any owner that works within the business must pay taxes on their distributive share as self-employment tax. Investors who don't actively contribute to decision-making within the company may be exempt from this self-employment tax. Typically, owners of an LLC pay twice as much employment tax as their employees since they have to match their employee contributions. Most states see taxation the same way that the federal government does - owners need to pay earnings on the income they receive from their businesses. However, in some jurisdictions, additional taxes may apply. In other jurisdictions, companies don't pay tax at all on their earnings. The IRS will also receive self-employment taxes from members of an LLC as part of their tax burden.
In addition to these taxes, some state boards have operating fees that need to be paid annually. The fee may be referred to as "franchise tax," the "annual registration fee," or the "renewal fee." Businesses registered within these states are required to pay these fees to retain their registration. A lawyer could help organize and arrange your tax filing and ensure that you're compliant with all the state laws and regulations regarding taxation.