From limited liability protection to a more organized business structure, operating a business as an LLC has its perks.But what happens at tax time? LLCs offer some flexibility when it comes to how a company can file taxes. However, as a business owner, if you are not prepared for these available options, then filing your taxes might be confusing, or you may be unable to reap some of the tax breaks that LLCs are known for. To help you navigate this, we’ve mapped out the ways that an LLC can be taxed and so you can be prepared for this.
Ways LLCs are Taxed in the US
In general, an LLC can stand as a single-member or multi-member limited liability company, which means that LLCs can still be filed under the business owner(s) personal taxes. However, LLCs can also be taxed as an S Corporation (Form 8832 with IRS). These are the two main ways that an LLC can be taxed and how your business decides to file will depend on how many business owners you have, the profits being reported, and whether or not you are prepared for acting as if your company were a corporation, among others. It is important to note that LLCs do not pay any state tax; however, if an LLC operates in a state with a higher tax rate, each member would want to take this into consideration because, if the LLC is filed as a pass-through for taxes purposes, then each member will be paying more in state taxes and self-employment taxes. If you are filing as self-employed, each member would need to estimate their taxes and withhold them throughout the year. You might then pay taxes quarterly (April, June, September, and January) so that you won’t be paying a huge fund come tax time.
Pass-Through Personal Taxes
The default way to file taxes as an LLC is to flow them through the personal income tax of each owner. How the income and losses are distributed to each owner is up to the business owner(s), but this is usually established in LLC’s Articles of Organization. If you opt for a flow-through structure, then you would report income as self-employed income as if that portion of your income were received as a sole proprietor. And, furthermore, each business owner would be filing self-employment tax reports in addition to the annual Schedule C of your Form 1040. All expenses deemed necessary and essential to your business can be deducted come tax time.Because of this, each owner will be subjected to self-employment taxes as both the employee and the employer (as if a self-employed individual would). For example, if you file as a sole proprietorship, your net income will be subject to federal income taxes and self-employment taxes. As a sole proprietor, you are responsible for paying self-employment taxes at a tax rate of 15.3%. This rate breaks down to 12.4% Social Security tax and a 2.9% Medicare tax for the first $137,700 of net income. An additional 0.9% for medicare may apply if your income is greater than $200,000. This tax rate is higher than traditional payroll taxes. If you were employed by someone else, this tax burden is shared between you and your employer meaning that you each pay 7.65% for a total of 15.3%.If you have a larger business (and potentially more partners or income coming through), it might be more difficult to divide the income. Additionally, the more income you are reporting, the more likely you are to pay higher self-employment taxes.
S Corporation or ‘Check the Box’
Any eligible LLC can “check the box” in the form 8832 of the IRS in order to elect to file taxes as an entity rather than flow-through personal income tax. Not all companies are eligible to file as an S Corporation; the business must have less than 100 members, only one class of stock, and only allowable shareholders. It must be a domestic company and not be an ineligible institution (like a financial institution or insurance company). The benefit of being an S Corporation for tax purposes means that you can file your company as if it were a corporation (its own business entity) and the taxes do not have to flow to the personal income of the business owners. In addition to this, come tax time, the business is subjected to a lower tax rate, and less income is subjected to that rate. When filing as an S Corporation, the business owners have to be paid a “reasonable salary”, which would then be taxed at the normal income tax rate for a salaried employee. The additional amount may be taxed as ordinary income (not self-employment) and at the cheaper corporate tax rate.
Benefits of Filing as S Corp
If you decide to “check the box” and file as an S Corporation, you can seek the tax benefits of a corporation without having to go through a lengthy registration process, pay expensive fees, or deal with the hassle of maintaining the business requirements every year (like holding shareholder meetings). Therefore, by this method, an LLC can get a corporation taxation cut for less work. LLCs might find that they are withholding a large amount of their profits, called retained earnings. However, by treating their company as a corporation for tax purposes, the profits kept in the LLC can be taxed at the separate income tax rate that corporations are subject to.Once an LLC elects to file as an S Corp, then the owner’s personal income taxes do not take on the income of the business. Instead, the first USD $75,000 profits are subjected to a lower overall tax.
Filing Your Taxes as an LLC
You might be wondering why the company wouldn’t just want to register as a corporation in order to seek this benefit. Recognize that filing as an S Corp is a bigger burden than filing pass-through. Businesses need to be prepared to file as if the company was its own entity for five years as well as filing the required annual reports. Even if filing as an S Corp, the business might also pay annual franchise taxes, which is essentially a flat fee for incorporating or registering with a state. The amount and when you pay will depend on the state you are filing with, your business income, business assets, and the number of shares your business has. This tax is usually due at the end of the year along with the annual report; guidelines vary by state so be sure to check your state’s guidelines. Note that once you elect to file as an S Corp, you can’t switch back to the pass-through taxation method for at least five years. Therefore, before you make the move, ensure that you are certain that you want to file as a corporation for tax purposes. If you are unsure of this process, you can also work with a service or accountant knowledgeable in business and tax law.