How Does the Taxation System Work in an LLC?

LLCs give you the option of choosing how you want you be taxed. The IRS does not have a specific tax classification for it. You may choose to be taxed as a Corporation (c or s), a sole proprietorship if you own a single member LLC ,or a partnership if you own a multi-member LLC. By default, an LLC is taxed as a pass-through entity (a sole proprietorship or partnership).

Under this system, an LLC does not pay federal income tax on its own income, but instead all the profits and losses of the LLC ‘pass-through’ to its members who report them on their personal tax return. Don’t confuse this with liability; even though all the profits and losses of your LLC are reported on your income, you still won’t share its liability.

What’s the Best Taxation Option for an LLC?

Usually the “Pass-through” taxation system is better because it protects your company against the “double taxation system” that is applicable on corporations. Corporations have to pay federal income tax on all their income, then tax must be paid again on an individual level when this income is passed through to company employees and shareholders in the form of salaries and dividends. You can save hundreds or thousands of dollars if you opt for the “pass-through” taxation system.

Is The Pass-Through Taxation System Always Better?

No. The “Pass-through” taxation system won’t suit companies that like to retain earnings for future expansions. In a pass-through taxation system, the portions of profits and losses of an LLC will be taxed regardless of the fact that the company retains a portion of earnings into the company. This can be problematic.

If you think you will regularly retain a large portion of your profit into your company then it’s better that you adopt the corporation tax system for your LLC.

There are mainly two types of LLCs:

  1. Single-Member LLC
  2. Multi-Member LLC

Single-Member LLC

By default, a single-member LLC is taxed as a sole proprietorship. To file taxes for a single-member LLC, you must report your profits or losses on the Schedule C of your income tax form 1040.

Multi-Member LLC

When an LLC is formed by two or more members, then it’s considered to be a multi-member LLC. As per the guidelines of IRS, a multi-member LLC will be taxed as a partnership.

To file your taxes for a multi-member LLC, you must report your profits or losses on the schedule E of your personal income tax form 1040.

All LLCs must prepare a K-1 that outlines the share of profits and losses of all the members of the LLC. The members will use the details outlined in the K-1 to fill out the schedule E of their personal income tax from.

You also need to file the income tax form 1065 for informational purposes – as mentioned above you do not have to file taxes directly on the income of your LLCs.

An Interesting Exception: Husband & Wife LLC

Usually an LLC that’s formed in Texas by two members is considered a multi-member LLC … but if the two members are married to each other, then your company will be treated like a single-member LLC for tax purposes. This is cool, because it’ll save you a lot of paperwork!

Self-Employment Taxes

If you’re an active member of an LLC, then you must pay self-employment tax and medicare on your share of profits, along with the federal income tax. Passive members are exempt from paying these taxes … lucky them!

Minimize Your Self-Employment Taxes

If you want to minimize your self-employment taxes, then you should have your LLC taxed as an s-corporation. Under this system, the owners of an LLC are entitled to receive a reasonable salary as compensation for their services. Anything that the owners receive above and beyond their salaries is considered their return on investment. Now the catch here is that in s-corporations, the self-employment tax will be applied only on the salaries of the members, they won’t have to pay these taxes on the extra profits that they earn.

There are a lot of tax-hacks that you can use to minimize your taxes, but it can be quite complex to get it all right. I strongly recommend that you consult a tax professional to help you decide what’s the best system that suits your company structure and helps you minimize your taxes!

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