LLC Taxation

A deeper look at the various LLC tax classifications

An LLC is typically taxed as a pass-through entity. As such, all of the profits pass-through the LLC to the owners/members, who report the profits on their personal tax returns. Unlike a c-corporation, the LLC does not pay federal taxes on its income.

Federal Tax Classifications

When LLCs were first invented the IRS decided not to create a new tax classification, but rather allow the LLC to choose from the existing tax classifications (sole proprietorship, partnership, or corporation).

Unless you tell the IRS otherwise, a single-member LLC will be taxed as a sole proprietorship; and a multi-member LLC is taxed as a partnership. Tax flexibility is one of the reasons the LLC is so popular. Below you can read about the various tax classifications available to a Texas LLC.

Disregarded Entity (Single-Member LLC)

A single-member LLC is treated by the IRS as a “disregarded entity”. This means the profits simply pass-through the owner. Most single-member LLC are owned by an individual and thus the LLC is tax like a sole proprietorship for federal tax purposes. Just like a sole proprietor, the member will report business profits on Schedule C of his/her personal Form 1040 tax return. The member will pay income tax on the profits at their individual tax rate as well as an additional 15.3% in self-employment taxes (social security and medicare).

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Partnership (Multi-Member LLC)

An LLC with more than one member (i.e. multi-member LLC) is treated by the IRS as a partnership for tax purposes. Although a multi-member LLC does not pay federal income taxes, it does have to file a partnership tax return (Form 1065) annually by March 15th. The multi-member LLC must also issue a K-1 for each member outlining each member’s share of profits. The members will then use the K-1 to report their share of the LLC’s profit on Schedule E of their personal federal tax return. The members will pay income tax on the profits at their individual tax rates as well as an additional 15.3% in self-employment taxes (social security and medicare). Members who are not active in the LLC (i.e. passive investors) may be exempt from paying self-employment taxes on their share of profits.

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S-Corp LLC

An LLC can elect to be taxed like an S-Corporation by filing Form 2553 (aka the S-Corp Election). The reason an LLC would make this election is to reduce the self-employment tax obligations of the LLC’s owners. Any member who works in or helps manage the LLC business must pay social security and medicare (these are often jointly referred to self-employment taxes) on his/her share of profits. One way to reduce the self-employment tax obligation is to elect for the LLC to be taxed as an S-Corp. Any owner who is also a salaried (w-2) employee of the LLC, will pay self-employment taxes on his/her salary (not his/her share of the profits). The salary must be reasonable.

Read more about S-Corp LLCs
What is required to be taxed as an S corporation?
Why would an LLC want to be taxed as an S corporation?
What is the definition of an S Corp?
Can an S-Corp Election be revoked?
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C-Corp LLC

An LLC can elect to be taxed like a C-Corporation by filing Form 8832. Each of the tax classifications above are all “pass-through” classifications meaning the LLC’s profits pass-through to the owners who then pay income tax on their portion of the profits (regardless of whether the LLC chooses to retain the profits for future use or distribute profits to the members).

An LLC taxed as a C-Corporation is not a pass through entity. This means the LLC will file a corporate tax return and pay corporate taxes on the profits. As of the writing of this article, the Trump Tax plan would reduce the Corporate tax rate to 21% (down from 35%). The owners would also pay income tax on any distributions or dividends they receive from the C-Corp LLC. This is sometimes referred to as double taxation and one of the big reasons a C-Corp LLC is rare.

Read more about Corporate Taxation
Please note that tax issues are complex and we are business formation attorneys, not tax specialists. As such, we must recommend that you consult a tax professional if you have specific questions or special circumstances. According to IRS Circular 230 to ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this writing was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.