In limited liability companies (LLCs), a single person usually isn’t fully responsible for company debts. Like other business owners, you’ll have to pay taxes if you’re a member of this type of entity. LLCs are taxed differently depending on whether they’re classified as partnerships, sole proprietorships or corporations.
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How LLCs Work
LLCs haven’t been around for a very long and the way they operate depends on how many people are involved. The laws they follow tend to vary from state to state. Some states say that LLCs can be owned by one person, while others require them to have at least two owners.
Basically, LLCs fuse together elements of partnerships and corporations. Much like shareholders in corporations, there is limited liability so that individual members of LLCs are only held accountable for their personal investments in the company and won’t be ruined by company debts.
At the same time, LLCs can be run like partnerships. All earnings are distributed among the owners, with LLC income taxed as individual income rather than corporate income. We’ll talk more about this later.
Besides limited liability, LLCs have a few other advantages over other types of businesses. Their management structure is relatively flexible and decisions (including those related to profit sharing) can be made by the owners themselves. If you stack them up against S corporations, LLCs are cheaper businesses to establish and owners don’t have to complete as much paperwork.
Unfortunately, if one of the members dies, files for bankruptcy or walks away from the company, the entire business must go away. And LLC owners typically have to pay the 15.3% self-employment tax.
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Single-Member LLC Taxes
Speaking of taxes, let’s say that you’re the sole owner of an LLC that sells pizza. In the eyes of the IRS, your company is considered a sole proprietorship. From a tax standpoint, you (the owner) and the business are one and the same and your pizza joint doesn’t pay any income taxes unless your state has special rules that say it has to.
Instead, you would include the company’s profits and losses on your personal income tax return and on Schedule C, C-EZ, E or F. In addition to self-employment taxes, your business will be subject to excise taxes. For these types of taxes, you write the company name and employer identification number on the employment and excise tax returns.
If you prefer to file as a corporation, you can complete Form 8832. If you live in a community property state and you and your spouse own the same business, you can file as a sole proprietorship or a partnership.
One big question is, how does an LLC that functions as a sole proprietorship have limited liability? If there’s only one member, isn’t his business in trouble if he has personal financial problems?
It depends. In some states, creditors cannot directly come after an LLC regardless of whether it has one member or three. In others, a creditor may be allowed to foreclose on a single-member LLC if an owner can’t pay off his debts.
Taxing an LLC as a Partnership
LLCs with two or more members are considered to be partnerships unless the company owners file Form 8832. The LLC itself usually doesn’t owe taxes, but as mentioned above, the tax burden gets split between the business partners.
Owners of LLCs that act as partnerships are expected to file Form 1065. Also, each partner will include their slice of the business’s credits, deductions and income on their own copy of Schedule K-1. Depending on their income, each member pays their portion of the self-employment tax and puts some of the details from Schedule K-1 on their personal income tax return (Form 1040).
Partial partners who have some stake in the company are obligated to pay LLC taxes as well based on their individual contributions. They often get a pass, however, when it comes to self-employment taxes.
Taxing an LLC as a Corporation
LLCs that choose to be treated as corporations must first submit Form 8832. Then, the company turns in a corporate income tax return (Form 1120). None of the members report any corporate losses or gains on their individual tax returns.
Being grouped in with other corporations may be a good idea if your LLC is bringing in a lot of revenue. That’s because sometimes partnerships and single-member entities can be taxed more heavily than corporations. Plus, as part of a corporation, you won’t pay taxes on money that hasn’t been distributed to you.
What’s not so great is the fact that as a corporation, you might face double taxation, meaning you’re taxed twice (once for your company earnings and then again for your dividends).
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S Corp Taxes
It’s also possible to turn your LLC into an S corporation for tax purposes. To do this, you’ll file Form 2553 within the first two months and 15 days of the tax year. Once your status has been changed, you’ll fill out Form 1120S to provide a record of the company’s profits and debts.
Not familiar with S corporations? Essentially, they’re set up like your standard C corporation. But instead of taxing the business, shareholders pay S corporation taxes on the earnings they receive.
Each shareholder of the LLC may have to include their income on Schedule K-1 that accompanies Form 1120S. They might be liable for some income taxes, although they’ll likely pay less toward self-employment taxes and avoid double taxation altogether.
As with S corporations in general, LLCs that wish to be identified as S corporations will need to abide by certain regulations. For example, they cannot have more than 100 members and none of those members can be partnerships, corporations or non-resident aliens.
The Bottom Line
A limited limited liability company can be established by one person or built around an existing LLC or corporation. LLCs file taxes just like everybody else does, based on state laws and how they’re classified. There are many limited liability company taxes, from estimated taxes paid four times a year, to property taxes and payroll taxes.
Before you decide that you want your LLC to be identified as a C corporation or an S corporation, it’s important to think about how the switch might affect your business from a tax perspective.
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