An LLC (Limited Liability Company) is similar to a sole proprietorship or partnership in its IRS classification as a “pass through entity.” Unlike a corporation, an LLC is not a separate entity that pays federal and state income taxes. The owners of the LLCs are called members, and any profits or losses realized during the tax year are reported on the personal tax returns of the members. Certain states assess annual taxes on LLCs, but federal income taxes are not paid directly from the LLC.Federal Income taxes.The number of member owners in the LLC will determine whether the IRS considers the business a partnership or sole proprietorship.Single-Owner LLC.For the LLC with one member, the IRS treats this business as a sole proprietorship for federal tax reporting purposes. All tax returns are filed will the tax identifier of the member and not directly from the LLC.

Schedule C of the sole owner’s 1040 tax return is used to report LLC profits or losses. All funds present in the company bank account at the end of the fiscal year are included in the asset calculation, and the IRS imposes tax on the money even if the funds are designated for future expenses or business expansion in the coming year.

Multi-Owner LLC.

For tax purposes an LLC with multiple owners is viewed as a partnership by the IRS. The LLC with multiple owners does not file federal tax returns under the LLC tax identifier. Each LLC member pays taxes on their individual share of the company profits through the filing of their personal income tax return using Schedule E. The initial LLC agreement sets forth the distributive share belonging to each member. Profits and losses are shared according to this agreement.

Profit Division. Members share the profits according to the operating agreement of the LLC. Each member’s share is distributed in proportion to the actual percentage of the business owned by the member. In special circumstances, the LLC profits can be divided without consideration of the percentage of ownership, which is considered, “a special allocation.”

Taxes Assessed on Distributive Share.

Even when a special allocation is used, the members will pay taxes on the distributive share as documented in the LLC agreement. When the LLC does not distribute all of the funds associated with the full distributive share, which happens for many reasons, the member is still responsible for paying the federal taxes on the entire share. Money left in the LLC will be taxed by the IRS regardless of the distribution at the end of the fiscal year. When business plans require funding for expansion or capital expenditures, the cash is left in the company, and the member’s pay the income taxes due.

IRS Form 1065

The LLC tax identifier is used to file form 1065 each year. Business partnerships also file this form as an informational IRS tax return. The IRS compares the information reported on this form against the LLC member tax returns to verify the taxes paid by each member. The LLC will provide a completed Schedule K-1, which specifies the distributive shares and the profits (or losses), for each member. After the information is received, the member will file an individual Form 1040, which includes a completed Schedule E.

Corporate Tax Rules Might Benefit the LLC

Certain LLCs find that corporate tax rules are more beneficial to the members and the business because substantial profit funds, which are called “retained earnings,” must be left in the business each year. The members of the LLC can elect to follow corporate tax rules according to the IRS. IRS Form 8832, Entity Classification Election, is filed with the corporate tax treatment box on the form checked.

Taxable income rates on the first $75,000 of corporate income are substantially lower than individual tax rates. The LLC owners will benefit from following corporate taxation and save money every year on federal income taxes.

Income Tax Estimates and Payments

LLC members are self-employed business owners according to the IRS. As such, tax withholding is not kept out of their earnings. Throughout the business year, each member is responsible for saving sufficient funds to pay taxes at the end of the fiscal year. Quarterly income tax estimate payments must be made to the IRS (and the state revenue office wherever state income taxes are collected). The standard April, June, September, and January schedule is followed by LLCs.

Self-Employment Tax

Both halves of the self-employment tax, which is made up of the Social Security and Medicare contributions, must be paid by each LLC member directly to the IRS. Employers normally pay one-half of these contributions, but members are not employees of the LLC.

Partners that do not actively participate in the business operation can file for exemption from the self-employment tax. All active LLC members are requird to pay the self-employment tax on the distributive share, which is defined as their rightful share of business profits.

Every LLC member required to pay the self-employment tax will report the assessed amount on Schedule SE, which is attached to the standard Form 1040 tax return. The additional half of the self-employment tax can be quite shocking when the owner has always had that tax paid by an employer, but this extra half is also deducted from the taxable income which reduces the income tax burden.

Each year the IRS maintains the same percentage for Social Security and Medicare withholding, which is 15.3%, but increases the amount of annual income on which the tax is paid. Once the income threshold is reached, only the Medicare tax of 2.9% is paid on the rest of the taxable income.

Deductions and Expenses.

LLCs are able to deduct the cost of conducting business, so the income tax rate is applied to the taxable income after expenses. Legitimate business expenses are tracked closely throughout the year and then deducted from the business income. When the dollar amount is positive, the business has realized a profit, and income taxes and self-employment taxes are paid on that amount. If the number is negative, the business has incurred a loss. Valid business expenses that may be deducted include: travel, vehicle costs, start-up, equipment, promotion, and property-related expenses. Specific rules apply to these expenses and keeping detailed records is essential for accurate filing.

State Income Taxes and Fees

In states that collect income taxes, LLC members will pay state income taxes on the personal tax return. The LLC does not pay state income tax directly.

Special Cases.

Some states assess state income tax on directly on every dollar of income the LLC earns. This tax is in addition to the state income tax paid by the owners. California taxes all LLCs that make more than $250,000 each year.

State Annual Fees.

Certain states assess an annual LLC fee that is not directly related the income of the business. Different names are used for this fee, including: renewal fee, franchise tax, or annual registration fee. The amount of the fee varies widely – from $100 to $800 – depending on the state.

Prior to establishing an LLC, investigate the state regulations and charges associated with LLC ownership. All fees are detailed in the tax code on the website of the proper state tax authority.

Understanding the LLC tax laws is essential to paying appropriate taxes without being fined for the unknown. Consult a tax professional and stay up to date on the ever-changing tax code at the federal and state levels.