So you’ve decided to form a new limited liability company (LLC), and you want to make sure you understand how they’re taxed — or, you already started your business and you’re scrambling to play catch-up. Either way, I’m here to help you understand your options well enough to make an informed decision for your LLC.
One of the most popular reasons to form an LLC in the first place is to take advantage of the structure’s “pass-through” taxation model, but what does that even mean? And is it the right form of taxation for your unique LLC? Read on to find out.
How is a Single-Member LLC Taxed?
Typically, a limited liability company with just one member is taxed like a sole proprietorship. What this means is the LLC itself is not taxed as an entity, and you don’t have to file any sort of business tax return with the Internal Revenue Service (IRS). Instead, as the LLC’s sole member, you report any business profits or losses on your personal income tax return.
Furthermore, it does not matter if you’ve transferred the profits from your business bank account into your personal bank account yet or not — you must pay taxes on all your business profits from the full year, whether or not you’re personally benefiting from the money.
This type of taxation is why the LLC is said to have pass-through taxation. The business itself is not required to pay taxes, but rather the profits and losses are passed through the business to its owner.
How is a Multi-Member LLC Taxed?
If your limited liability company has more than one owner — whether that means two members or two thousand members — the company is taxed much like a partnership. The default taxation method is to split the profits evenly amongst the LLC’s members and to have those members each claim their portion of the company’s taxes as part of their personal income tax return.
However, there are other options available. If your LLC has uneven ownership shares among its members — say, if one owner holds 60% of the company, and two other owners own 20% each — you can choose to split your profits (and therefore the tax responsibility) to match each member’s ownership share. To do so, you’ll have to file what’s known as a special allocation, which will be accepted at the discretion of the IRS.
Much like the single-member LLC, this is a pass-through method of taxation. It doesn’t matter if you’ve moved the actual money itself into your personal bank account — all owners are responsible for their entire share of the profits each year.
One drawback of the limited liability company as a business type is that each member is responsible for self-employment taxes. This is the government’s way of extracting the employer share of Social Security and Medicare from a self-employed person by essentially doubling the rates of these taxes.
As such, the previously discussed methods of taxation for single-member and multi-member LLCs are both subject to self-employment tax, which is currently set at 15.3%. (For reference, the typical employee share of Social Security and Medicare is 7.65%.)
Tax Cuts and Jobs Act of 2017
It’s not all bad news on the self-employment tax front though, as the recent Tax Cuts and Jobs Act of 2017 created a qualified business income deduction of 20% for members of pass-through entities — LLCs, partnerships, sole proprietorships, and S corporations. This means that only 80% of the business income claimed on your personal tax return is taxable, which is a major departure from the previous law which dictated 100% taxable business income for pass-through entities.
It should be noted that this deduction is only available for owners of small-to-medium sized businesses. More specifically, if you claim more than $157,000 in business profits on your personal return — or more than $315,000 for a jointly filed return — you will have to pay tax on 100% of that income, just like everyone used to under the previous system.
LLCs Classified as Corporations
It is also an option for a limited liability company to elect to be taxed like a corporation — either a C corp or an S corp. What are these options, and why would you consider them for your company? Let’s find out.
C Corporation Tax Designation
The C corporation is the more common form of corporate tax designation, mostly because the rules and regulations for maintaining it as a tax structure aren’t nearly as restrictive as those of S corps. The problem with C corps is the “double taxation” model — business profits are first taxed on a corporate basis, and then on your personal return as well.
When it comes to the corporate tax rate, it’s currently 21% — representing massive savings over the previous 35% rate. Also, self-employment tax does not apply to an LLC with a C corp tax classification, so that’s another silver lining. Still, because C corp business profits are claimed on your personal tax return as dividends at capital gains rates (up to 23.8%), the double taxation format can make your tax bill add up in a big hurry.
The C corp tax format is typically only advantageous for very high-income LLCs, whose members are in one of the top individual tax brackets.
S Corporation Tax Designation
Alternatively, you can choose to have your LLC taxed like an S corporation, which is actually pretty similar to the way single-member LLCs are taxed. Basically, it’s exactly the same in just about every way, except for one key benefit — the S corp tax designation allows shareholders to be classified as employees, which can provide a tax break.
Again, the S corp tax designation is really only a good idea if you’re certain the shareholder-employee option will save your members money. In my experience, quite a few businesses elect to be taxed as S corps, only to realize they’re not saving nearly as much money as they’d hoped — often not enough to justify the extra paperwork.
I will note that S corp designations do prevent you from having to pay self-employment taxes, which is a benefit that’s less significant now that there’s a 20% deduction for most small and medium-sized businesses.
Generally speaking, it’s not worth over-thinking the taxation options for your LLC, because the majority of businesses won’t save enough money by electing C corporation or S corporation tax designations to make the mountain of paperwork worth it.
Still, as you now know, there’s a reason some LLCs do choose these options — usually as a way of decreasing what would otherwise be a very large tax bill.
No matter which designation you choose for your LLC, good luck in all your business endeavors.
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