How Is an LLC Taxed?
The Delaware LLC is the most popular type of legal entity amongst small businesses. A Delaware LLC provides bullet proof liability protection for business owners’ personal assets while avoiding the red tape involved with maintaining a corporation. Entrepreneurs prefer LLCs because they are flexible, cost effective, and easy to set up.
Forming an LLC is simple, however, you may find it more difficult to understand how LLCs are taxed. The taxes an LLC pays can vary depending on how the company is structured. Here are some important points to consider about LLC taxation.
How Is an LLC Taxed?
The beauty of an LLC is its flexibility in choosing what tax structure works best for your business to keep your taxes as low as possible. For federal tax purposes, an LLC has flexible tax treatment, and the way it is taxed depends on how it is set up and whether any IRS tax elections have been made.
By default, an LLC is treated as a pass-through entity. This means the LLC itself does not pay federal income tax. Instead, profits and losses pass through to the owners, who report that income on their personal tax returns. The default for a single-member LLC is to be taxed as a sole proprietorship, also known as a disregarded entity, with income and expenses reported on Schedule C of the Member’s personal Form 1040 tax return. A multi-member LLC is taxed as a partnership by default with just the IRS informational return Form 1065.
LLC owners also have the option to change how their business is taxed. Many LLCs, owned by US citizens or green card holders, are eligible to elect to be taxed as an S corporation by filing a timely Form 2553 tax election with the IRS within 75 days of formation. This election can be used to save thousands of self-employment tax because of how owners are paid and whether the business pays corporate-level taxes or passes income directly to shareholders.
Note that real estate owners should always choose an LLC and leave it taxed as a partnership or disregarded entity to minimize capital gains tax in the future.
Because LLC taxation involves several “check-the-box” options, even opting into C-Corporation tax structure through a timely IRS Form 8832 election. Because of the potential implications, many business owners work with a CPA to determine the best approach. Choosing the right tax classification can affect overall tax liability, compliance requirements, and long-term financial planning for the business.
What Happens If I Don’t Pay My LLC Taxes?
Failing to pay your LLC Franchise Tax to the State of Delaware leads to penalties, interest, and loss of the protection of the LLC shield and ability to conduct business legally under the LLC.
At the state level, many states require LLCs to remain in good standing by paying Franchise Taxes and filing annual reports if required. Failure to pay and file required Franchise Tax results in penalties, administrative dissolution and revocation of the LLC’s authority to operate.
Unpaid Franchise Taxes can also create practical issues, as banks, vendors, and licensing agencies often require proof of good standing to maintain accounts or approve transactions.
How Do I Calculate My LLC Taxes?
Calculating LLC Franchise Taxes in Delaware is easy because the Franchise Tax is a flat annual fee of $400 required to keep your Delaware LLC in good standing and is due regardless of income or assets. Separately, your LLC has an obligation to report federal, and possibly state or local, income taxes based on earnings.
Because LLC tax calculations can involve multiple layers, many business owners work with a CPA or tax professional to help estimate payments and stay compliant throughout the year.
Do LLCs Pay Tax?
LLCs conducting business operations will likely incur state and federal tax obligations along the way. The Internal Revenue Service treats LLCs as “disregarded entities” for federal tax purposes. These are also known as “pass-through” entities. The profits and losses pass-through the business to its sole member and are reflected on the member’s personal income tax return. The business does not pay taxes directly and does not have to produce a tax return.
The default federal tax status of an LLC will depend on how many members are associated with the company.
Single-Member LLCs Are Taxed As Sole Proprietors.
Single-member LLCs have a default tax status of sole proprietor.
The sole member of a single-member LLC reports income and expenses on the Schedule-C of the IRS Form 1040 tax return.
Multi-Member LLCs Are Taxed As Partnerships.
An LLC with more than one member defaults to a partnership tax status for federal tax purposes. A partnership is another type of pass-through entity. Each member must file an informational partnership tax return IRS form 1065 along with a Schedule K-1 stating their share of the profits or losses of the business.
In Delaware, members can agree to distribute profits and losses disproportionate to their ownership in the company. For example, two members of a Delaware LLC with equal, 50% ownership can agree to split business profits 90% and 10%. Members can make arrangements for distributions through the private LLC Operating Agreement without making any public filings. This is an example of the flexibility provided by a Delaware LLC.
It is important to note that profits passed through an LLC to its members are considered “earned income”. This type of income is subject to the burdensome self-employment tax rate.
Can LLCs Be S-Corps or C-Corps?
The IRS’ “check the box” rules allow LLCs to make corporate tax elections. This means that LLC members can choose to have their company be taxed as either a C-Corporation or an S-Corporation.
C-Corp Election for LLCs
Under the C-Corp election, business profits are effectively taxed twice. First, the LLC’s business income is taxed at the flat corporate tax rate. The 2017 Tax Cuts and Jobs Act set the corporate tax rate at 21%. Additionally, corporate dividends are subject to tax on the owner’s personal tax return.
An LLC can make the C-Corporation election on IRS form 8832. The LLC will need to file an 1120 US Corporation Income Tax Return.
The C-Corp election has a negative reputation because of double taxation, however, it does have some advantages. Surprisingly, a C-Corp election can actually result in the lowest possible tax rate for certain businesses if structured properly. C-Corps benefit from being able to determine a fiscal year. This allows a company to carry forward profits and make deductions from a series of losing years before it becomes profitable.
It is recommended to consult with a tax advisor within 75 days after forming an LLC to decide which tax election is best for your business.
S-Corp Election for LLCs
The S-Corp election, like a partnership, allows the profits and losses of a business to pass through the LLC to the owners. This effectively allows the LLC to avoid double taxation on corporate income. As an S-Corp, the LLC pays a salary to its members which is subject to personal income tax. After paying a reasonable salary, the company can distribute dividends. Dividends made by an S-Corp are treated as passive income and are not subject to self-employment tax.
An LLC can make the S-Corporation election on IRS form 2553. The LLC will need to file an 1120-S US Corporation Income Tax Return.
It is advisable to allocate no more than 50% of corporate income to the “S dividend”. The IRS could consider an excessive S dividend to be an abuse of the tax code.
What are the Restrictions for LLCs Taxed as S-Corps?
Making an S-Corp tax election can provide an LLC with several business benefits. However, an LLC needs to meet certain requirements in order to qualify for the S-Corp election.
- Can Only Have up to 100 Owners- An LLC wanting to make an S-Corp election cannot have more than 100 owners. This includes individuals with ownership or membership interest in the company.
- No Foreign, Non-U.S. Owners – All the owners in the LLC must be U.S. citizens or permanent residents in order for the company qualify for an S-Corp election.
- Not Owned by Other Legal Entities – An LLC electing to be taxed as an S-Corp cannot be owned, either full or partially, by any other entities. These include corporations, partnerships and other business structures.
- Only One Class of Stock – Entities taxed as S-Corps are only allowed to issue one class of stock. LLC’s do not issue stock, however, LLCs do make distributions to their members. An LLC taxed as an S-Corp can only make distributions proportional to each member’s ownership interest in the company.
How Much Do LLCs Pay in Tax?
The percentage of federal tax that an LLC has to pay will vary depending on the amount of income that the business brings in. Since business income generated by the LLC is reported on the Members’ personal tax returns, that income will be taxed at their personal income tax rate.
U.S. federal income tax rates are structured in multiple brackets, with the lowest tax rate starting at 10%, and the highest topping out at 37%.
Doe LLC’s Pay Annual Fees?
Many states require LLCs to pay an annual fee often called the “annual franchise tax”. The franchise tax is essentially a fee to maintain an LLC’s privilege of limited liability protections year after year. The franchise tax is typically a flat fee which does not change based on income. In Delaware, the annual franchise tax is $400 and is due on March 1 of each year after formation.
You should consult with a tax professional to determine which tax status is best suited for your business.
Do LLCs Need an EIN for Taxes?
Yes, most LLCs need to obtain an Employer Identification Number (EIN) from the IRS. An EIN number, also known as a Federal Tax ID number, is the type of unique identifying number that the IRS assigns to businesses for federal tax purposes.
An LLC needs an EIN number to complete many common tax filings. However, an EIN number is required many other critical business functions, including opening business bank accounts and hiring employees in the U.S.