How the LLC Pass-Through Taxation Works

Limited liability companies (LLCs) are what’s called “pass-through entities.” This means that the business does not pay corporate income taxes. Instead, the individual owners or members of the LLC collect its proceeds as income and then pay personal income taxes on the results. Here’s how the LLC pass-through taxation works. A financial advisor with tax expertise can help you optimize your tax strategy and potentially save you money. Find an advisor today.

What Is an LLC?

An LLC is a type of business entity governed by state law, so the details of how LLCs work will differ by jurisdiction. Most states, however, share the same general frameworks.

An LLC works similarly to a partnership. The owners of the company are referred to as members and, unless otherwise specified, share ownership and operating duties. Depending on how you structure the LLC, the IRS will consider it as either a partnership, a corporation or an expense on the individual operator’s tax return.

The essential aspect of an LLC is that it insulates its members from liability for the company’s debts and liabilities. This means that the LLC uses its own accounts to pay all bills. If it cannot pay its debts, the creditor cannot seek payment from the LLC’s members.

This is the key difference between an LLC and a partnership. While both entities are similar, partners share the liability of their business while LLC members do not. The LLC structure allows people to start a company without taking on the risk that they will be personally ruined if the company fails.

How Are LLCs Taxed?

Taxation is one of the most significant differences between an LLC and other forms of corporations. In virtually all cases, LLC are treated with what’s known as “pass-through taxation.” This means that the LLC does not file its own corporate income taxes. Instead, after the LLC pays its bills and debts, the members collect its remaining revenue and pay taxes on that income.

This is the case no matter how you distribute the LLC’s money at the end of each year. This means that even if you leave the company’s money in its own bank accounts, the individual members have to report those profits on their personal income taxes.

There are no upper or lower limits to how many people can form an LLC. One person can form an LLC on their own, or many people can join together to do so. This creates two main forms of taxation: individual operators (or “single members”) and multi-member corporations.

Individual Operator LLCs

When an individual forms an LLC on their own, the IRS treats the company as a sole proprietorship.

Like with all LLCs, the company itself does not file any taxes. Instead, after the company collects its revenue and pays its bills, the remaining profits or losses pass through to the individual owner’s income taxes. The owner includes all profits for the LLC, or takes a deduction for any losses, as part of their overall taxes for the year.

Most of the time, an owner will report their LLC’s profits and loss as either self-employment income or business income.

Multi-Member LLCs

For multi-member LLCs, the IRS classifies the company as a partnership for tax purposes. While the LLC itself doesn’t file a separate income tax return, it must submit certain forms to report its profits and losses to the IRS. Once the company generates revenue and covers its expenses, the remaining profits are distributed to its members. Members then report these earnings or losses on their personal tax returns.

The method of profit distribution depends on the structure of the LLC. By default, most LLCs divide profits equally among all members unless stated otherwise. However, it’s advisable for an LLC to establish an operating agreement. This document outlines the operational rules of the company, including how profits and losses are allocated among members.

Typically, an operating agreement will stipulate one of two approaches:

1. Equal profit sharing among members. This is common in businesses with low overhead, such as professional services.
2. Profit sharing based on each member’s investment in the company. This is frequently used in high-overhead industries, like real estate.

Managing the retention and distribution of profits is crucial for multi-member LLCs, especially when the business is more complex than a sole proprietorship or small partnership. Larger LLCs often retain a portion of their profits to cover future expenses and operating costs.

That said, members of an LLC are taxed on their proportional share of the company’s profits, regardless of whether those profits are distributed. Therefore, it’s essential to have a clear and equitable system for deciding how much to distribute versus retain. This helps ensure members aren’t unfairly burdened with taxes on earnings they haven’t received.

Bottom Line

An LLC uses what’s known as pass-through taxation. This means that the company does not file or pay its own taxes. Instead, the LLC members claim the entity’s profits or losses as part of their taxes. Even if an LLC’s profits are left in its own bank accounts at the end of the year, the members of the LLC will still owe personal taxes on the money.

Tax Planning Tips

• When it comes to their taxes, some people need a professional in their corner, someone like a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you considering setting up an LLC, be sure to familiarize yourself with the ins and outs of this business structure. Learn more about how this corporate form works in our full primer on LLC taxes.
• Estimating how much you may owe the IRS in taxes or how large of a refund you can expect to receive can be critical to building an accurate financial plan for the year. SmartAsset’s tax return calculator can help you estimate and plan ahead.

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