One of the most frequent questions we get from business owners at the time of company formation is 'How are LLCs taxed'?
This is a very interesting question as there is no single answer and may vary based on the tax classification that you choose at the time of company formation.
Firstly, there are two most important key steps:
1) Choosing the right entity structure - LLC/INC
2) Choosing the correct tax classification- sole proprietorship ( 1 member LLC), Partnership ( multi-member LLC), S Corporation or C Corporation.
Let's look at each tax classification and the taxation
Single member LLCs - There is only 1 member in this LLC.
All single member LLC members are considered as a sole proprietorship for taxation purposes. So, as such the LLC doesn't pay any taxes and it doesn't have to file taxes under the LLC name. All taxes will be paid by the owner as a sole proprietor. All taxes will pass through the owner's personal taxes. The owner also needs to be pay quarterly estimated taxes each quarter based on income & will file form Schedule C as a sole proprietor.
As the only member of the LLCs, all profits and losses are reported on this form Schedule C along with your form 1040 tax return.
If there is more than 1 member, you have formed a multi-owner LLC. Multi-owner LLCs are considered as partnerships, therefore the same taxation rules apply as a partnership. The partnership will need to file form 1065. Special rules may apply for members in community property state, so consult with a tax professional.
In most cases, the profits and losses are distributed based on partnership share of each partner. Each LLC member's share of profits and losses called a distributive share should be provided in the operating agreement.
Again, LLCs do not pay taxes and LLC does not file a tax return. All income and losses pass through the partner's income tax returns. After preparing from 1065, each partner will receive from K1 outlining the partner's profits or losses. Later, each partner will report this profit and loss on their form 1040.
LLCs electing to opt for Corporation status: This can be done by filing form 8832
If you need to retain substantial profits in your LLCs as retained earnings, you may elect to be taxed as a corporation. You will file form 1120
As an LLC taxed as a corporation, this option will allow LLCs to offer owners and employees tax advantages through stock options, fringe benefits, and other stock ownership plans. Please also note that the first $75,000 of corporate taxable income may be lower than the individual income tax rates and so may bring additional tax savings in overall taxes. This is the reason why it's extremely important to understand your projected income for first few years as per your business plan so you can choose the right tax classification based on your business situation.
LLCs who elect to be taxed as an S Corporation: You will complete form 2553 within first 75 days of the financial year to be taxed as an S Corporation. You need to receive a confirmation letter from IRS. S Corporations have various limitations based on # of members, residency status etc. Therefore, you need to carefully choose this election if you think S Corporation may be the right option for you.
As an S Corporation, you are required to take a Salary as you will be considered an owner-employee. Eg: You earn $100,000 a year, you will need to determine a reasonable salary based on your tax situation eg: 60,000. Please, however, note that there has been a lot of discussion around S corporation salary. Therefore, consult a qualified Certified public accountant who specializes in S Corporations.
In short, you will be paying:
Payroll taxes as an employee. As an employer, you will be filing all the required 940, 941s, W2s,1099s.
As an S Corporation, you do not have to pay medicare and social security taxes on your distributions. EG: If you have $200,000 annual income and you take $100,000 as salary. You pay $15,300 ($15.3% as taxes).
If you do not choose S Corporation taxes, you will incur additional Medicare ($2,900) and social security taxes (1,252)
Because of this tax advantage, many LLCs now elect to be taxed as an S Corporation. Please note that you need to take salary otherwise there will be IRS scrutiny which in turn may lead to penalties and interest.
As an S Corporation, you will file form 1120 S and distribute K1 to the owner-employee
How to file taxes for an LLC with no income? It varies. If you are single owner, report in your schedule C.
If you are multi member LLC, report in form 1065 all your expenses.
As a S Corporation, you will enter the same in form 1120S and for C corporation you will enter the expenses in form 1120.
The tax treatment will vary based on tax structure as you will now have net operating losses.
So, we highly recommend discussing your projected income/losses ahead of time with a tax professional if you have not yet formed the entity. If you have formed the entity, discuss with a CPA so he or she can suggest and provide analysis on how your net operating losses will be treated for taxation purposes.
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