LLC Member Tax FAQ

Navigating the world of taxes can be challenging for small business owners, especially those operating as limited liability companies (LLCs). This article breaks down frequently asked questions about LLCs.

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What is an LLC, and how is it taxed?

A limited liability company, or an LLC, is a flexible business entity. It blends elements of a partnership and a corporation. For federal income tax purposes, an LLC can be a disregarded entity, a partnership, or a corporation, based on its tax classification. Single-member LLCs are considered disregarded entities. They report business income on the owner's personal income tax return using the Internal Revenue Service (IRS)'s Schedule C form.

Multi-member LLCs are typically taxed as partnerships, with profits and losses passed through to owners' individual returns. However, an LLC can also elect to be taxed like a corporation, including S-corps and C-corps, which have their tax implications. For example, in the case of an S corporation, you can avoid double taxation.

How do business owners file taxes for an LLC?

Business owners must first determine their LLC's tax classification to file correctly. For a single-member LLC, the owner files a Schedule C with their personal income tax return. They report business income and expenses. Multi-member LLCs file Form 1065 and provide each member with a Schedule K-1 showing their share of profits or losses. 

If the LLC is treated as a corporation for tax purposes, it must file a separate corporate income tax return using Form 1120 or 1120S for S-corps. Business owners should maintain separate bank accounts and records for their LLCs to streamline tax filing and avoid personal liability.

What tax deductions and credits are available to LLCs?

LLCs can access various tax deductions and tax credits, which can reduce their taxable income and overall tax liability. Common deductions include business expenses like rent, utilities, supplies, and salaries. LLCs might qualify for specific tax credits depending on their type of business and activities, such as credits for research and development or for hiring certain employees. 

It's essential for business owners to keep detailed records of all expenses to substantiate these deductions and credits. Consulting a tax professional can help identify the most beneficial deductions and credits for your LLC.

Do members of an LLC pay Medicare and Social Security taxes?

Yes. Owners of an LLC are responsible for paying Medicare and Social Security taxes on their earnings. These taxes are also called self-employment taxes. For single-member LLCs (sole proprietorships) and multi-member LLCs treated as partnerships, the business income passed to the owner is subject to self-employment taxes. This covers Medicare and Social Security contributions. These taxes are calculated on the net earnings of the business. 

LLC members must report profits on their individual 1040 tax returns and pay estimated self-employment taxes. However, if an LLC elects to be taxed as an S-corp, the owner-employee's salary is subject to Medicare and Social Security taxes. Dividends or distributions, however, may not be. Because profit distributions from an LLC are not wages, an LLC member must make estimated tax payments on a quarterly basis to the IRS. Taxpayers must make payments in April, June, September, and January.

An active member of the LLC is responsible for paying the entire amount of the self-employment tax, or 15.3 percent. The IRS does allow the taxpayer to deduct half of the self-employment tax from their adjusted gross income as a business expense, however. If the member is not active in the daily business of the LLC, the IRS may exempt the member from paying the tax.

What are the state-level tax considerations for an LLC?

LLCs must also comply with state tax laws, which can vary significantly. Some states impose a franchise tax or fee on LLCs, regardless of income. Additionally, the requirements for reporting and paying state taxes differ based on the state's tax law and the type of business. LLC owners should check with their state's secretary of state and tax agency for specific guidelines. It's vital to understand these requirements to avoid penalties and ensure compliance with state tax laws.

What if an LLC likes to keep a substantial amount of profits in the business instead of distributing it to the members? Will our LLC benefit from electing corporate tax treatment?

The IRS will automatically categorize an LLC as a sole proprietorship or a partnership for tax purposes. If an LLC prefers tax treatment as a corporation, it must make a formal election with the IRS. This option may help a company that needs or chooses to keep a significant amount of the profits in the business. Doing so, however, has consequences for the members.

Even if the LLC never distributes a member's entire share, the IRS requires the member to pay income taxes on the distributive share the member is entitled to receive. This can result in members having to pay taxes on money that they can't even use. Corporate tax treatment may still save members money, however, since the applicable corporate tax rate is lower than the highest possible individual tax rate.

Questions About Your LLC Tax Obligations? An Attorney Can Help

When it comes to LLC tax benefits and liabilities, these matters are usually best left to the experts. A legal professional can walk you through the process and help you decide which business structure is right for you and how it will impact your own tax situation.

Reach out to an experienced tax attorney in your area today.