One question we get a lot is whether LLC taxes are based on profits or owner draws and how LLC taxes actually work. Unfortunately, because we’re talking taxes, there’s no simple answer.
It depends on how you structure your limited liability company. So let’s dig in.
How do LLC Taxes Work?
Typically, limited liability companies are treated as pass-through entities for federal income tax purposes. This means the LLC doesn’t pay business taxes on profits directly. Instead, each member or manager’s share of the business profits “pass through” to their personal tax returns.
However, there are some exceptions, and the way LLC members pay taxes on their share of profits depends on the LLC’s business structure.
How LLCs Pay Federal Income Taxes
LLCs have a lot of flexibility in choosing how the Internal Revenue Service (IRS) taxes profits. They can be taxed like a sole proprietorship, partnership, S corporation, or C corporation.
How a Single-Member LLC Pays Income Taxes
Single-member LLCs—those with a sole owner—are treated like sole proprietorships as far as the IRS is concerned.
Essentially, this means the LLC reports business income and expenses on Schedule C. This Schedule gets filed with their personal tax return – it’s not a separate return.
How a Multi-Member LLC Pays Income Taxes
The IRS treats multi-member LLCs like partnerships.
This means the LLC files a partnership tax return using IRS Form 1065. But the LLC doesn’t pay taxes on business earnings. Instead, LLC owners receive a Schedule K-1. Members use the K-1 to report their share of the profits or losses on Schedule E, which gets filed with their personal return.
Income Taxes for LLCs Classified as Corporations
LLCs can also elect to be taxed like an S Corporation or C Corporation for federal tax purposes.
S Corporations file taxes using Form 1120-S. Like a partnership, each member receives a Schedule K-1. This schedule is used to report their share of the profits or losses on their personal tax returns.
If the LLC chooses to be taxed like a C Corporation, it files a tax return using Form 1120. Since a C Corporation is not a pass-through entity, the business pays any applicable income tax.
Are LLC Distributions Taxable?
Typically, no. That’s because the business owners are taxed on their share of profits and losses, whether or not they actually distribute profits.
To be clear, this answer applies only to the default classifications for LLCs: single-member LLCs and multi-member LLCs that haven’t elected to be taxed like corporations. We’ll cover S corp taxation in another blog.
Now, let’s discuss why this can be so confusing to small business owners.
When getting a business off the ground, LLC members often reinvest business income into the company rather than taking a distribution. Then they’re surprised to discover that they still owe taxes on the LLC’s profits, even though they didn’t receive any money.
For example, say Meghan and Kate choose LLC as their business structure for their professional organizing business. In their first year of business, they have $20,000 in net income but don’t take any distributions. Instead, they leave the money in the business bank account, knowing they need the money to hire another employee and purchase a van for hauling supplies.
Even so, Meghan and Kate each owe federal income tax and self-employment taxes on $10,000 of business profits—their 50/50 split of the $20,000 of LLC income—when they file their tax returns.
This can be frustrating for business owners who aren’t expecting a big tax bill at the end of the year. The bright side is that since Meghan and Kate pay tax on the income when it’s earned, they don’t have to worry about double taxation when they later take those profits out of the business, as is the case with C Corporations.
How Do LLCs Pay State Taxes?
Most states tax LLCs the same way the IRS does, with LLC members paying state income taxes on their personal returns. However, some states charge a gross receipts tax based on the LLC’s gross income. Others might charge an annual fee regardless of income.
Pass-through taxation is complex, and the structure you select can have a big impact on the amount of tax you pay. If you aren’t sure where to start and need help figuring out how LLC taxes work, please reach out! We’d love to help you choose the right business entity for you.