LLC Taxation
Taxes and member classifications
By default, a Texas LLC is taxed as a "pass-through entity" and all of the profits and losses of the LLC "pass through" the LLC to the members, who report the profits and losses on their personal tax returns. Unlike a c-corporation, the LLC itself does not pay federal taxes on its income.
Federal Income Taxes
The IRS does not have a specific tax classification for LLCs. Generally speaking, a single-member LLC is taxed as a sole proprietorship and a multi-member LLC is taxed as a partnership. Don’t confuse tax classification with the limited liability protection provided by the LLC (i.e. a single-member LLC is taxed as a sole proprietorship, but the sole member is NOT considered a sole proprietor for liability purposes).
Single-Member LLCs
A single-member LLC is treated by the IRS as a sole proprietorship for tax purposes. Just like a sole proprietor, the member will report business profits (or losses) on Schedule C of his/her personal Form 1040 tax return. Read more about single-member LLCs.
Multi-Member LLCs
An LLC with more than one member (i.e. multi-member) is treated by the IRS as a partnership for tax purposes. Just like a partnership, the members will report profits (or losses) on Schedule E of their respective personal 1040 tax return. Although the multi-member LLC does not itself pay federal income taxes, it does have to file Form 1065 with the IRS. Form 1065 is an information only return (no payment necessary) used by multi-member LLCs and partnerships. The multi-member LLC must also prepare a K-1 for each member outlining each member’s share of profits (or losses). The members use the K-1 to complete Schedule E of their Form 1040.
Husband and Wife LLCs
An LLC that is owned by two members who are married to each other can elect to be taxed as a single-member LLC in Texas.
Consider Corporate Taxation. It is important to note that members pay federal income tax on their portion of profits and losses each year regardless of whether the LLC chooses to retain the profits for future use or distribute profits to the members. This "pass through" feature can be problematic for some members. One of the benefits of a Texas LLC is the ability to choose to be taxed as a corporation if it so desires. If you will regularly need to keep a substantial amount of profits in your LLC (called “retained earnings”), you might benefit from electing corporate taxation (i.e. by filing IRS Form 8832).
More on Corporate Taxation →Self-Employment Taxes
As of the writing of this article, any member who works in or helps manage the LLC business must pay Social Security and Medicare (self-employment taxes) on his/her share of profits in addition to the income tax described above. However, 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.
The self-employment tax rate is 15.3%. This rate consists of 12.4% for Social Security and 2.9% for Medicare. The amount of profit that is subject to the self-employment tax is set by law and changes annually.
Consider S-Corporation Taxation. An LLC can elect to be taxed as an s-corporation and then may the owner(s) of the LLC a reasonable salary as compensation for their services. The amount of the LLC’s profit that is over and above the the salary can be considered a return on the member’s investment and would not be subject to self-employment tax. In other words, a member who receives a reasonable salary is only required to pay self-employment taxes on the salary and not his/her share of the LLC’s profit.
The ability to minimize self-employment tax can be a huge benefit, but is very complex. Should you have questions about self-employment or income taxes, including the implications of your entity decision and IRS elections, you should consult your tax professional.
