How Does an LLC Business Pay Taxes?
BY: AUSTIN ANDRUKAITIS ON FRIDAY, JANUARY 11, 2019
Taxes can be confusing and complicated at the best of times. The fact of the matter is that most business owners or directors are not tax experts. They have other valuable skills that have allowed them to create a successful business.
On the surface, an LLC is much like any other business. Business owners have clients to whom they provide services. However, the structure of an LLC can vary based on the number of people involved in the organization, the tax needs of the organization and its partners, as well as the jurisdiction the LLC is operating in.
Feeling a little confused already? When talking about LLCs and taxes, it’s easy to feel overwhelmed at first. Luckily, much like any other business, a little bit of research can go a long way when it comes to filing taxes.
This article will help shed some light on LLC business taxes, clear away the confusion that can arise come tax time, and tackle the myths that always seem to pop up any time taxes become the topic of discussion. By the end, LLC business taxes won’t feel nearly as complicated or daunting as before.
What is an LLC?
Getting the most basic definitions out of the way is important to ensure that everyone is on the same page when reading this article. For those involved in an LLC, this will feel a lot like an open book test. For those considering starting an LLC or looking ahead to the first tax filing, these definitions may be important to review.
LLC is short for limited liability company. Many people incorrectly believe that the “C” in “LLC” stands for corporation and assume that all LLCs are corporations. If that were the case, then this article could be a copy and paste of corporate taxes and everyone could go home early.
Due to some similarities between LLCs and corporations, it is understandable why many people confuse the two. The main reason business owners would choose to form an LLC or incorporate is to reduce the liability of the individual shareholders in the business. However, despite that very similar purpose, there are many differences between the two types of organizations.
For starters, an LLC is formed by owners. This could include a single owner or a group of owners. These owners are referred to as “members” within an LLC. They are not shareholders, as they would be in a corporation.
Another major difference has to do with profits and losses. In a corporation, the business is a completely separate entity from the individual shareholders and all profits or losses are the responsibility of the business. In an LLC, on the other hand, profits or losses are passed to members.
Finally, the way that taxes are applied to an LLC when compared with a corporation can differ greatly. This is one of the main reasons business owners will choose to register as an LLC.
An LLC Comes in Many Shapes and Sizes
It’s impossible to simply say, “This is how an LLC pays taxes,” because there is no single type of LLC to use an example. In fact, there are several types of LLCs that are all structured differently and consist of varying numbers of members.
Before determining how an LLC is taxed, the type of LLC must be determined. For example, a single member forming an LLC is very similar to a sole proprietorship. There are also general partnerships that include several members, family limited partnerships, as well as other forms of LLCs that are only recognized in certain states.
All of these various LLC structures can complicate the process of sorting out taxes. The fact that different states may allow different types of LLCs complicates thing even further. For the purpose of this article, however, we will focus on the most common types of LLCs that can be found from coast to coast in the United States.
Why Form an LLC?
So far, the different types of LLCs and misconceptions about LLCs and corporations may have some wondering why anyone would even go through the trouble of forming an LLC in the first place. However, there are several reasons that this makes sense from a tax standpoint as well as a business standpoint.
First, an LLC limits the liability of members. If the business has debts, lawsuits, and other challenges; those must be dealt with through the business. This means that members cannot be held responsible personally for the debts of their business. In the case of illegal acts or negligence, however, members may still be held personally responsible.
The above is why professionals like doctors, lawyers, and accountants form an LLC to do business. These professions may be more prone to lawsuits, for example, and wish to protect their personal assets from any lawsuits that may arise against their business. That isn’t to say that many other business owners couldn’t benefit from forming an LLC.
Taxes are the second main reason that business owners form an LLC. Unlike corporations, an LLC passes profits onto members and the members pay taxes personally. In many ways, this simplifies the tax process where members have a direct input into the success of the business and, therefore, a direct interest in the profits of the business as their personal income. This avoids so-called double taxation of corporations where taxes are paid on income and then taxes are also paid on dividends paid out to shareholders.
Finally, setting up an LLC is much more cost friendly and less intensive than setting up a corporation. There is no need to file separate tax returns at year end, the costs of registering are much less significant when compared with incorporating, and personal assets are still given limited liability protection.
What Are LLC Business Taxes?
As the previous section hinted at, LLC taxes are treated much like personal income rather than separate business taxes as taxes would be treated with a corporation. This can make tax filing much more simple for business owners who want the protection of a limited liability without the complicated processes that accompany incorporating a business.
In many cases, an LLC is referred to as a passthrough business. This is a simple way of describing how profits and losses are managed within an LLC. The financial considerations of the business are passed through to the members of the organization who then file their taxes personally as they would normally.
While that is a simple way of describing LLC business taxes, the finer details can change based on the specific type of LLC in question. Each type of LLC will have slightly different rules on how taxes must be handled.
Single Member LLC
As the name suggests, this is an LLC with a single member. For tax purposes, this type of LLC is treated much like a sole proprietorship would be treated. The LLC business is managed by the sole owner with the main difference being that an LLC offers limited liability while a sole proprietorship does not.
For business owners that have been operating for some time, the question often arises about when to incorporate or form an LLC. Forming an LLC is a much more popular option as it is less costly and time consuming. In addition, the member can continue managing their business and taxes in the same way they were previously.
Tax deductions for business purposes can be claimed on personal income to help reduce the tax burden of the member that oversees the day-to-day operations of the LLC.
General Partnership LLC
This is the second most common type of LLC chosen by business owners. A general partnership LLC would be the appropriate type of LLC if there is more than one person with an interest in the business.
When registering as an LLC, different members are named, and they can be given different percentages of ownership in the business. The interest does not always necessarily have to be split equally between all members. This slight nuance, however, can affect tax obligations in a big way.
For a very simple LLC where two members have equal interest, the profits and losses can easily be split among members and there is little question about who is responsible for what. Things become slightly more complicated when multiple members are involved with varying levels of interest in the business.
For example, a 5-person LLC could see 1 member hold 60% interest with the remaining 4 members holding 10% each. When profits and losses are distributed accordingly, the members could have different tax obligations from one another.
Despite this one complication, filing taxes as a member of a general partnership LLC can still be much simpler than filing separate returns for corporate taxes as well as personal taxes on dividends earned.
Family Limited Partnership LLC
This type of LLC is very similar to a general partnership LLC but, as the name suggests, all members are from the same family. Family members can hold property within the LLC, designate members to control the property, and change membership as-needed.
For all intents and purposes, a family limited partnership should be treated much like a general partnership LLC should be treated. This is a less common form of LLC as it is increasingly less common for families to see the need to group assets into a business entity.
This is a much less common form of LLC as it is only available in a handful of states including Iowa, Nevada, Illinois, Utah, Texas, Oklahoma, and Tennessee. The structure of these LLCs is similar to other LLCs with one major notable change. In a Series LLC, there are smaller cells within the parent LLC and debts or obligations can be assigned to each individual cell.
As a result, collectors can only pursue individual cells for the debts they are owed. This can help to protect parent LLCs from debt obligations held by other cells. It does not, however, change the tax responsibilities for the members of the LLC.
LLC Business Taxes are Personal Taxes
If this article could be boiled down to one line, it would be the header above. People unnecessarily complicate the concepts of LLCs and the tax responsibilities associated. This is often a result of confusion with corporations.
It’s important to remember than an LLC is a passthrough business and any earnings made by the business will be passed along to members of the LLC based on their ownership interest in the business. Once the profits have been passed along, individual members are responsible for incomes taxes as they would if they were simply operating as a sole proprietorship or partnership that had not yet registered as an LLC.
Business tax deductions are claimed on the personal tax returns which also makes taxes a little simpler for individuals that are filing. In a partnership situation, business expenses would be claimed based on a percentage of the interest that each member had in the LLC and its associated expenses. This may complicate things slightly, but good tracking of expenses and solid communication should overcome any obstacles.
Sometimes LLC Taxes Are Not Personal…
Just when everything looked nice and clear, this section pops up. While basic LLC taxes can be relatively simple as far as business taxes go, there is another wrinkle that may be added to the entire situation.
An LLC may, if the members wish, apply to be taxed as a corporation. There are some tax advantages to doing this if the members are high income individuals and the corporate tax rate is determined to be a more beneficial way to manage taxes. These LLCs are known as S Corporations.
This is not the most common way to pay taxes as an LLC, but it is important to understand as it can radically change how the LLC and its members are taxed.
Don’t Forget the State and Local Taxes
Finally, it’s important to remember state taxes when filing. This is where LLC business taxes can vary from state to state.
The good news is that most states use the IRS definition of an LLC and, as such, the business is treated as a pass through business meaning members are individually responsible for taxes. However, some states do take on their own definitions of how an LLC should pay business taxes and people in those states should be aware of their unique requirements.
These rules can regularly change as state governments change. For example, Florida doesn’t charge a separate business tax for LLCs that are sole member LLCs. However, partnership LLCs and S Corporations must pay business taxes.
New York City applies an additional tax to LLCs but, otherwise, the income taxes are treated the same way as in the federal tax system.
These are just a couple examples of how LLC taxes may vary from jurisdiction to jurisdiction. Being aware of the local or state rules regarding LLCs can help business owners make a more informed decision when deciding whether or not to register as an LLC.
Which Businesses Should Register as an LLC?
Unfortunately, there is no simple way to determine in a blog if a business should register as an LLC or not.
This is a decision that may offer a lot of benefits without introducing new tax complications which makes it an attractive solution for many business owners.
However, there may be situations where choosing to incorporate makes more sense, despite the additional tax complications this may introduce.
It is advised that business owners consider all of their options and look beyond just tax responsibilities before making a final decision. If needed, it may be wise to consult with a tax professional that can help lay out all of the pros and cons as they relate to local, state, and federal tax responsibilities.