Understanding How LLC Members Pay Taxes
Limited liability companies (LLCs) are one of the most popular types of business entities. The LLC's flexible taxation options are one reason it is preferred. LLC members can, for the most part, choose how they would like to be taxes. The LLC enjoys this flexibility because the Internal Revenue Service does not recognize it as a distinct entity for federal tax purposes. It must, therefore, be taxes as on of the four taxable options already available:
A disregarded entity is a business structure that is not recognized as distinct from its owner for tax purposes. If you are the sole owner of a LLC, the IRS classifies your company as a disregarded entity by default and taxes the LLC as a sole proprietorship. As a result, the owner of a single-member LLC must report the LLC's income and expenses on the members Form 1040 Schedule C. A separate tax return fo the entity is not required.
When a LLC has multiple members, the IRS's default classification for tax purposes is the partnership. Partnerships, like disregarded entities, pass their income and expenses down to their owners, and LLC members are responsible for paying taxes proportionate to their ownership interests. Income, credits and deductions are reported to the IRS using Schedule K-1 (Form 1065).
If an LLC does not want to be taxed as either a sole proprietorship or a partnership, it can be elected to be taxed as a corporation by timely filing Form 8832. Electing taxation as a corporation can be beneficial in several ways. If the company does not intend to pay out dividends, electing to file taxes as a corporation allows LLC members to avoid reporting the business's income on their personal income tax return. Because personal income tax rates are often higher than corporate income tax rates, this may allow individuals to benefit from the lower corporate income tax rate. Additionally, LLC members may avoid paying self employment taxes. Thus, corporate taxation may have money saving benefits for LLC members.
The S corporation tax election is unique. The S corporation meets all of the following criteria:
1. It has less than 100 owners;
2. All of its owners are United States citizens or residents
3. It has only one class of membership
4. Its membership is not comprised of any partnerships, corporations, or non-resident aliens
If an LLC chooses to be tax as an S corporation, the LLC members show pass through taxation unlike a standard corporation. Moreover, the income that is taxed as a distribution is not subject to self employment tax. Finally, an S corporation allows its owners to take advantage of the Qualified Business Income Deduction of up to 20 percent. There are some limitations as to which industries qualify for this unique deduction. You must timely file the IRS form 2553 to elect S corporation taxation.
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