Filing federal taxes as a limited liability company is different than filing as a corporation. Here’s the rundown for business owners looking to make a specific election with the IRS.
LLCs at a Glance
An LLC is a pass-through entity for IRS purposes. This business structure is governed at the state level, but unlike a corporation, it does not pay federal income tax. Instead, all profits and losses filter down to the individual owners who then report their shares on their personal returns. Owners are referred to as members and may be individuals or other companies. Few jurisdictions impose any kind of minimum or maximum number of parties allowed. In general, you must have at least one member, but tax law excludes banks and insurance companies from operating as LLCs.
LLC members enjoy a considerable degree of flexibility when it comes to taxes. Key advantages include the following:
- No corporate tax return
- No double taxation
- No residency or citizenship requirement
- Owners hold limited liability for company debt
- More credibility for investors Here are some disadvantages:
- No stock options for investors
- Limited growth potential
- Different laws in different states
- Owners pay self-employment tax
The IRS treats an LLC as a sole proprietorship, partnership or a corporation. Some of the above advantages do not apply under the corporate election. In any case, you still get to write off all business expenses, including travel costs, equipment, advertising and supplies. In general, an LLC member is much like a self-employed taxpayer. As such, he or she is responsible for paying twice as much Social Security and Medicare tax as a W-2 employee. Fortunately, half of this is deductible.
LLC Filing as a Sole Proprietor
If you’re the only member in an LLC, you will be solely responsible for all taxes related to the business. This means filing Schedule C and SE along with your personal 1040.
LLC Filing as a Partnership
If you have two or more members, you may file under the partnership tax rules, in which case your LLC would not pay tax on company earnings. All profits and losses are split between individual partners. However, the business is still required to file a 1065 partnership form for informational purposes. Schedule K-1 itemizes each partner’s share. These numbers are then transferred to the individual returns. For example, assume you and your colleague operate a small consulting business that brings in $50,000 in annual revenue and incurs $20,000 in annual expenses. Each partner should receive a Schedule K-1 that lists $25,000 in income and $10,000 in deductions. In other words, the taxable income on your personal 1040 will increase by $15,000.
LLC Filing as a Corporation
This election requires a separate entity tax return to report all business income and deductions. Information goes on IRS Form 1120. The main benefit of this reporting structure is the limited liability. Failing to file a company return will not affect the personal taxes of your owners. On the other hand, you’re looking at double taxation. All owner dividends are considered taxable income on the 1040.
Making the Election
As a sole member in an LLC, your default tax classification is sole proprietorship. Likewise, with two or more members, you will default to a partnership. If you wish to change your classification, you must make an Entity Classification Election using Form 8832. In general, you can prorate your status up to 75 days prior to your election filing date. You may also file in advance, but the election must take effect within one year after you file. If you simply invest in an LLC without taking part in managerial decisions, you may be except from self-employment taxes on distributed profits. Whether you’re an investor or an owner, be sure to consult with an accountant or tax lawyer if you have any questions.
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