The limited liability company (LLC) is a hot business structure for startups right now for good reason. It offers all the personal-liability protection without the red tape, paperwork and formalities that can be burdensome for a startup, a small business or a solo entrepreneur.
After settling on the LLC as the legal structure, many small-business owners are surprised to learn they have to decide how to be taxed. This is a big decision, since taxes are probably what drove you to choose this legal structure in the first place.
Because the LLC is an entity created by state statute (and not the federal government), it has flexibility for federal tax treatment. A single-member LLC can be taxed as a sole proprietorship or a corporation (either a C corporation or an S corporation). A multi-member LLC can be taxed as a partnership or a C corporation or an S corporation.
Flexibility is a good thing, but you need to know which LLC option is right for you. Here are the four federal tax classifications available for the LLC.
1. Single-member LLC as a ‘disregarded entity’
A single-member LLC is essentially taxed as a sole proprietor. As the name implies, you need to be the sole owner of the LLC. This classification falls into the "pass-through" taxation category—the business doesn’t file any tax forms. As the owner of the LLC, you report business income or loss on your personal tax forms (Schedule C).
You need to pay self-employment taxes if you’re engaged in active trade or business, such as providing a service like copywriting or selling a product. If you formed an LLC for a passive activity, such as a real estate investment, then you don’t pay self-employment tax on the profits. (You report your passive profits on Schedule E).
For example, Jonathan is a freelance UI designer who formed an LLC for his business. He earned $75,000 in profit in 2011. He reports this income on his personal tax form amd pays income taxes on the $75,000 at his individual tax rate, and he pays self-employment taxes.
2. Multiple-member LLC as a partnership
If an LLC has two or more members, it will be taxed federally as a partnership, unless it elects to be taxed as an S corp or C corp (see below). A multi-member LLC taxed as a partnership reports its business income on a separate 1065 partnership tax return. Then, each partner pays self-employment taxes on his share of the partnership profit on the Schedule SE tax form. As with the single-member LLC, you only pay self-employment taxes if the LLC engages in an active trade or business.
3. LLC as a C corporation
An LLC can elect to be treated as a corporation for tax purposes by filing Form 8832 with the IRS. The LLC files a corporate tax return 1120 and pays taxes on its profits at its corporate tax rate. If LLC profits are distributed to LLC owners in the form of dividends, those dividends are taxed again at the qualifying dividend rate (this is what’s known as double taxation).
The LLC profits are not subject to self-employment taxes. But an LLC treated as a C corporation is responsible for payroll taxes on any wages paid to LLC members who work for the business.
If you prefer to keep profits in the company rather than distributing end-of-the-year profits to owners, a C corporation would work. In this case, only the company is taxed on the profits; individual owners are not responsible for paying taxes on whatever money stays in the business.
For example, Judy owns a consulting company that earned $100,000 in profit. As an LLC treated as a C corporation, the business would pay $34,000 in taxes on this income (assuming a 34 percent tax rate). If Judy takes home that profit as a dividend, she would also owe taxes (at the 15 percent qualifying dividend rate) on the dividend payment. But if she decides to keep that money in the business (perhaps to expand her marketing budget next year), she does not owe any personal taxes on the profit.
4. LLC as an S corporation
In this last scenario, the LLC elects to be treated as an S corporation. The S corporation files an 1120S tax return, but the company’s profits are not subject to corporate income tax, as they are in the C corporation. Instead, individual LLC owners are taxed on their respective shares of the company’s profits (and profits are not subject to self-employment tax).
If an LLC owner works in the business, he must be paid a reasonable wage for his activities, and the LLC must pay payroll taxes on these wages.
Let’s say three friends start a social Intranet company, and each owns one-third of the business. They form an LLC and elect to be taxed as an S corporation. In the first year, the business earns $90,000 in profit. The LLC does not pay income tax on the profit. Instead, each owner includes his or her share of the profit ($30,000) in their taxable income on their individual tax return.
If the business lost $60,000 in the first year, each owner would include a $20,000 loss on individual taxable income.
Do your homework
Choosing the right tax entity for your LLC is an involved issue and will ultimately depend on all the unique aspects of your particular business needs, vision and circumstances. Investigate your options and stay on top of changing federal and state tax developments that could affect your taxes.
Because the decision can have significant financial implications, discuss your particular situation with a tax adviser or CPA.