How is an LLC Taxed?
A limited liability company (LLC) is a legal business structure offering liability protection to its members, similar to a corporation. However, the IRS does not consider the LLC to be a separate tax entity like a corporation. The IRS considers the LLC to be a “pass-through entity”. This means that business profits (and losses) “pass through”; the business directly to the owner’s personal tax return. While some states, like California, institute annual LLC taxation, the LLC itself does not pay federal taxes.
A business owner operating as a single-member LLC reports business profits and losses on Schedule C when filing their annual personal tax return (Form 1040). Multi-member LLCs are treated similarly, however, each member receives a Schedule K-1 showing their distributive share of profits and losses. This information is then reported with Schedule E on the member’s individual tax return. Unlike a single-member LLC, the multi-member LLC must also file a federal information return (Form 1065) with the IRS.
What about Self-Employment Tax?
Generally, an LLC member is not considered an employee so no contribution to Social Security or Medicare is withheld from pay. Members are responsible for paying these taxes themselves directly to the IRS. Some members may be excluded from this requirement if they are only capital investors rather than contributing owners affecting the day to day operation of the business.
Self-Employment Tax can also be avoided if the primary business activity of the LLC is passive. Passive activity is activity in which the owners of the company did not materially participate in during the tax year. Examples: Real Estate Holdings, holdings, royalties and such.
The LLC structure also provides members with the option of electing for different treatment by the IRS should the owners deem this advantageous. For example, in the event that members wish to hold significant profits within the LLC rather than distribute those earnings, the LLC may elect to be taxed as a corporation by filing the appropriate forms with the IRS without altering the legal ownership structure of the LLC itself.
An LLC can be taxed as a Sole Proprietor (Schedule C), Partnership (if more than 1 member), C-Corporation or S-Corporation.