LLC owners report business income and losses on their personal tax returns.
A limited liability company (LLC) is not a separate tax entity like a corporation; instead, it is what the IRS calls a “pass-through entity,” like a partnership or sole proprietorship. All of the profits and losses of the LLC “pass through” the business to the LLC owners (called members), who report this information on their personal tax returns. The LLC itself does not pay federal income taxes, but some states impose an annual tax on LLCs.
Income Taxes
The IRS treats your LLC like a sole proprietorship or a partnership, depending on the number of members in your LLC.
Single-Owner LLCs
The IRS treats one-member LLCs as sole proprietorships for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS.
As the sole owner of your LLC, you must report all profits (or losses) of the LLC on Schedule C and submit it with your 1040 tax return. Even if you leave profits in the company’s bank account at the end of the year — for instance, to cover future expenses or expand the business — you must pay income tax on that money.
Multi-Owner LLCs
The IRS treats co-owned LLCs as partnerships for tax purposes. Like one-member LLCs, co-owned LLCs do not pay taxes on business income; instead, the LLC owners each pay taxes on their share of the profits on their personal income tax returns (with Schedule E attached). Each LLC member’s share of profits and losses, called a distributive share, should be set out in the LLC operating agreement.
Dividing up the profits between members. Most operating agreements provide that a member’s distributive share is in proportion to his or her percentage interest in the business. For instance, if Jimmy owns 60% of the LLC, and Luana owns the other 40%, Jimmy will be entitled to 60% of the LLC’s profits and losses, and Luana will be entitled to 40%. If you’d like to split up profits and losses in a way that is not proportionate to the members’ percentage interests in the business, it’s called a “special allocation.”
Taxes assessed on entire distributive share. However members’ distributive shares are divvied up, the IRS treats each LLC member as though the member receives his or her entire distributive share each year. This means that each LLC member must pay taxes on his or her whole distributive share, whether or not the LLC actually distributes all (or any of) the money to the members. The practical significance of this IRS rule is that, even if LLC members need to leave profits in the LLC — for instance, to buy inventory or expand the business — each LLC member is liable for income tax on his or her rightful share of that money.
File Form 1065 with the IRS. Even though a co-owned LLC does not pay its own income taxes, it must file Form 1065 with the IRS. This form, the same one that a partnership files, is an informational return that the IRS reviews to make sure that LLC members are reporting their income correctly. The LLC must also provide each LLC member with a Schedule K-1, which breaks down each member’s share of the LLC’s profits and losses. In turn, each LLC member reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.
Consider Electing Corporate Taxation
If you will regularly need to keep a substantial amount of profits in your LLC (called “retained earnings”), you might benefit from electing corporate taxation. Any LLC can choose to be treated like a corporation for tax purposes by filing IRS Form 8832, Entity Classification Election, and checking the corporate tax treatment box on the form.
Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to most LLC owners, this can save you and your co-owners money in overall taxes.
