The LLC is popular choice when it comes to company formations, but business owners often have one very important question: How is an LLC taxed? The taxes an LLC pays can vary, but there are some important facts to know about LLC taxation.
Four out of five businesses that incorporate with IncNow choose the Delaware LLC over the corporation. The flexibility and simplicity of Delaware LLCs are key reasons for its popularity. By default, an LLC has a federal tax status of a partnership for a multi-member LLC or the tax status of a sole proprietorship for a single member LLC. These are “pass-through” entities for tax purposes. All of the profits and losses pass-through the business to its members (owners) or sole member. These owners then pay taxes on the profits, or deduct the losses, on their individual 1040 personal income tax returns. Therefore, the business entity does not pay taxes directly. Instead a multi-member LLC only files an informational partnership tax return referred to as an IRS Form 1065. Then its members receive a K-1 for their share of the profits or loses. By agreement, this amount can be distributed disproportionate to ownership percentage.
A single member LLC does not need any additional return other than the owner’s IRS Form 1040. For the single member LLC, it reports income and expenses on the Schedule-C of the IRS Form 1040 tax return. This results in all profits being automatically self-employment income. All the profits are treated as “earned income” subject to self-employment taxes. This tax can be burdensome and result in a higher effective tax rate.
What Is the LLC Tax Rate?
Because LLCs, by default, are “pass-through” entities, the owners pay taxes on the profits, or deduct the losses, on their individual 1040 personal income tax returns. LLC income to that owner would be taxed at their stardard tiered tax rate. The same is true for LLCs that elect to be taxed as S-corps, which only taxes personal income when it is reported on Form 1120S.
If an LLC elects to be taxed as a C-corp, they are subject to corporate tax rates and double taxation. Under the Tax Cuts and Jobs Act, C-corps pay a flat 21% corporate tax rate. In addition to the 21% corporate tax rate, corporate dividends will be subject to tax on the owner’s personal tax return.
There is also a “tax” owed in Delaware called franchise tax. We normally refer to this is as the “state fee” since it is always a flat $300 owed annually to Delaware and does not changed based on income.
Corporate Tax Elections and Double Taxation
To reduce the self-employment taxes, the owners can make the two corporate tax elections under IRS “check the box” rules on behalf of the LLC. This happens when the owners do not want the LLC to be taxed as a sole proprietorship or partnership. The two corporate tax elections are known as a “C” (on IRS form 8832) or “S” election (on IRS form 2553). Causing an LLC to make one of the two tax elections means the LLC will need to file an 1120 or 1120-S US Corporation Income Tax Return.
While LLCs taxed as C-corporations can result in “double taxation” that does not necessarily result in a higher effective tax rate. Counter-intuitively, sometimes the double taxation of a C-corporation can be managed and structured to result in the lowest available tax rate for your LLC. This often requires making someone else a 6% non-employee owner to avoid the personal service corporation rule. This rule is something unfamiliar to many accountants and lawyers, but it works and lets the first $50,000 of income be taxed at 15% rate which can then be borrowed from the company as a loan, not subject to tax.
Utilizing this technique should be done carefully and in consultation with a tax advisor. The main difference between the “S” and “C” corporate tax elections is that the “S” election allows the profits and losses to pass through the LLC to avoid double taxation on corporate income. This means only taxing the individuals on the personal amount distributed to them on a personal income tax level. After paying a reasonable salary, the remaining “S” corporation dividends are treated as passive income, not subject to self-employment taxes. This results in savings on the Medicare and social security tax allocated on up to half of a company’s income. Allocating more than 50% of an “S” corporation income to the “S” dividend, and not salary, can be considered abusive and is not recommended.
C-corps have a negative reputation because many think they always result in higher taxes. Surprisingly, a C-corporation election can lower your taxes if done properly on a modest consulting business or small operating company. The tax rate paid by the corporation can be low and the dividend then paid to stockholders is then taxed again as a dividend. The C-corp has the added benefit of being able to pick a fiscal year to allow for income shifting. The C-corp also allows profits and losses to be carried forward for a business with oscillating profits and losses or even a series of losing years before it becomes profitable. For example, a business with heavy equipment purchases should consider a C-corp from the beginning.
The business that should never make an S-corp election or be a C-corp is a real estate investment business. Land owners should always hold real estate through an LLC taxed as a partnership or sole proprietorship. That allows for profits from sales in the future to be taxed as long term capital gains rather than ordinary income, which is a lower effective tax rate.
Therefore you should consult with a tax advisor within 75 days after the formation of your LLC or corporation to decide if you want the default tax status or make a corporate tax election. You do not need to form a corporation to make a corporate tax election. Under the IRS “check the box” rules LLCs are also eligible for “S” and “C” tax treatment, but more importantly they default to partnership/sole proprietorship status and have many non-tax benefits superior to corporations.