Before considering any type of business entity, you’ll want to consider the pros and cons of each structure and what will work best for your business. One of the first questions that new business owners ask is this one: “How will my business be taxed?” For small business owners who choose to form an LLC structure, there are several options to consider.
Knowing the facts before considering the tax structure for your Limited Liability Company will keep you out of hot water. There are several options to consider. You may be taxed as a partnership or sole proprietorship, taxed as an S corporation, or taxed as a C corporation:
An LLC is usually taxed as a sole proprietorship or partnership. Under normal circumstances, the LLC is taxed as a partnership or sole proprietorship. In 1997, the IRS established federal default rules. The default rules say, if you have one owner, the LLC will be taxed as a disregarded entity, meaning all the profits and losses will show up on your personal tax return (if you are the owner). In this case there is no federal or state single member LLC that is disregarded for tax purposes.
If the LLC has two members, the default is to be taxed as a partnership. That means a 1065 is filed on April 15th federally each year. If you business is earning earned income all the profits are subject to self employment taxes in 2009 which is up to $106,800. If it is taxed as a partnership and one partner is not active (they work very few hours or are just passive) their distributions may not be subject to self employment taxes. Be sure to check with your CPA for exact input. For the one-owner LLC, you’ll file a 1040 tax return and attach a Schedule C.
As a Limited Liability Company taxes as a partnership, you’ll pay no federal income taxes when taxed in this manner. The LLC is often called a “pass through” entity. This means that each member (owner) of the LLC reports his or her share of the profits and losses on their individual tax returns, regardless of the number of members. LLCs with multiple members will report their individual profits and losses on Schedule C as well.
An owner may elect to S corporation tax status. Many LLC owners opt to elect S Corporation tax status because they can pay themselves a reasonable salary, tax that amount, and collect distributions from the company as surplus income. This often results in a substantial savings to the owners. First, the key is to file the federal 2553 certified to the IRS.
The EIN application is not enough to tell the IRS your entity is taxed as an S election. Plus you may have a home state form to file, make sure you check! For instance, an LLC owner that earns $60,000 and is taxed as a sole proprietorship will pay $9,180 in self-employment taxes ($60,000 X 15.3%=$9,180). If you elect an S Corporation tax status, you may choose to pay yourself a salary of $40,000 (a reasonable salary is required). That salary will be taxed at the same 15.3% rate, but you’ll save $3060 in taxes. You can then pay the remaining $20,000 as a distribution from the company.
What happens when an LLC elects corporation (C corporation) tax status? If you decide to structure your LLC as a corporation, you will need to file form 8832 to the IRS. Plus you will need to amend or update the operating agreement to note the language about the C corporation election.
You will pay federal income taxes on the profits if the LLC is taxed as a C corporation. At first, this may not seem like good business sense, but if you plan to expand the business one day and would like to leave the profits in the business, you could save on taxes in the long run. To benefit from this structure, the LLC should be generating profits since the first $75,000 is taxed at a lower rate than a sole proprietorship or partnership.
Tax laws can be confusing. When you form an LLC, consult a tax professional to help you decided which tax structure will work best for you. Since tax laws change from year to year, don’t leave your decision up to chance. What you don’t know may significantly hurt your bottom line.