Taxing a Limited Liability Company (LLC)
UPDATED: February 7, 2020
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One main advantage of a limited liability company rests in how the IRS treats the business under tax rules. Usually, an LLC is taxed as a partnership or a sole proprietorship, which means that the LLC pays no federal income taxes. The profits and losses are passed through to the members. Each member reports his or her share of profit or loss on his or her personal tax return. If each member owns 50 percent of the LLC, then each member will be responsible for paying 50 percent of the federal income taxes. Because only the partners or members are taxed, owners tend to avoid double taxation that would regularly apply to a corporation. In a corporate setting, the corporation would be taxed once for their profits, and then any recipients of profits (like shareholders) would also be taxed on their disbursements. With an LLC, owners are only taxed once under federal tax rules.
LLCs and Election to Be Taxed
Even though an LLC is a company, not a corporation, the LLC can file an election to be taxed like a regular corporation. Some LLCs, after consulting with a lawyer or Certified Public Accountant (CPA), decide that they would prefer to be taxed like a C corporation, which is a corporation that has not elected S corporation status. If the LLC makes that decision, its profits will be subject to the federal income tax. Especially if the business expects to earn profits that can be left in the business for future expansion, this arrangement can save on taxes since the LLC may be taxed at a lower tax rate than its members. Unlike partnership-style taxation, corporate taxation of an LLC is not automatic. You will need to file an election form with the IRS.
In addition to federal income taxes, an LLC may be required to pay any other types of state or federal taxes that are applicable to the business entity. Other taxes can include taxes relating to the employees who work for the LLC or franchise taxes imposed by the state.
LLCs and State Rules
The designation as a C corporation or a Sub S corporation will affect federal tax guidelines and rules. These designations may or may not affect state taxing requirements. Because limited liability companies are a relatively new form of business entity, the states do not have uniform rules regarding the creation and taxing of LLCs. Some states will accept and use the designation required for the federal government. Other states require a separate designation and filing to invoke changes in a LLCs tax status. Some states will tax an LLC as a corporation, regardless of their federal designation.
Neglecting federal or state tax rules can result in stiff monetary penalties. If you are considering forming or converting your business to a limited liability company, make sure that you consult with a corporate attorney that understands that overlap in federal and state tax laws applicable to your LLC.