Forming a limited liability company (LLC) is a common way to structure a small business. LLCs allow owners to enjoy certain advantages of incorporation while retaining tax benefits reserved for unincorporated partnerships.
In addition to providing protection against personal liability, LLCs are not automatically subject to separate corporate taxation, unlike C-corporations (C-corps). This makes an LLC an attractive option for many small business owners.
“There are benefits and drawbacks to each type of business and tax structure,” said April Walker, lead manager for tax practice & ethics with the American Institute of CPAs, in an email interview with The Balance. “There is no single choice that is always better for a business owner—the owner’s current needs and future plans should be evaluated by working with a professional.”
Benefits of Pass-Through Taxation
Unless otherwise designated by the owners, an LLC is not separately taxed as a business. For income tax purposes, the IRS treats the business as a partnership by default.
Instead, an LLC is taxed as a “pass-through” entity, meaning that income taxes are passed through to its owner or owners, who are known as “members.”
Members individually report income and losses from the LLC on their personal returns. This is generally considered an easier and cheaper process than filing for a C-corp.
For pass-through entities, this income is taxed up to the maximum of 37%. However, certain qualifying pass-through income is eligible for a 20% reduction through 2025, per the 2017 Tax Cuts and Jobs Act. The reduction would decrease the maximum tax rate to 29.6%. Generally, to qualify for the reduction, an individual must have earned up to $163,300, and a married couple filing jointly must have earned up to $326,600. However, the IRS outlines specific exceptions to these rules.
Along with LLCs, S-corporations, sole proprietorships, and partnerships are also considered pass-through entities.
Choosing Your LLC Tax Designation
LLC members can select from three different types of federal tax designations, including a non-pass-through corporation option.
Each state has its own requirements for the formation of LLCs including fee structure and operating rules, said California-based CPA Mary Kay Foss via email to The Balance. LLCs are state designations, not federal tax structures. Business owners looking to form an LLC must consult their state statutes. On a federal level, however, LLCs have flexibility when it comes to how they are taxed.
The following are the different types of federal tax classifications available for the LLC.
A single-member LLC—which is owned by one member—is considered a separate entity from its owner, unless that owner chooses another option on Form 8832. This is a pass-through designation, wherein the owner is essentially taxed as a sole proprietor. The business is not regarded as a separate, taxable entity.
LLCs with two or more members are designated as partnerships by the IRS for income tax purposes. In a partnership, two or more owners engage in a business and share in the profits and losses. Taxation is passed through to each individual member, and the business is not treated as a separate, taxable entity.
Individuals in partnerships are subject to self-employment taxes.
An LLC can elect to be taxed as a corporate entity if it chooses the option on Form 8832. These LLCs will follow corporate federal tax rules. Corporations are subject to Social Security, unemployment and payroll taxes.
Since a corporate designation allows organizations to raise capital through stock, the structure is a good idea for medium- to high-risk businesses that need to raise money, or if they plan to be sold or go public, according to the U.S. Small Business Administration.
C-corps and S-corps are the most common corporate tax designations.
- C-corp: This business entity will be taxed separately from individual owners. Federal income tax of the business entity is capped at 21%. However, C-corporations must also pay taxes on dividends and capital gains paid to the owner, resulting in double taxation. The latter rates can go as high as 40.8%.
- S-corp: Unlike a C-corp, an S-corp is considered a pass-through designation. Income, losses, deductions, and credits can be passed through to shareholders, thereby avoiding double taxation. An S-corp can have no more than 100 shareholders. Owners must file through the IRS to achieve an S-corp designation.
Owners of S-corps can receive a reasonable salary, and unlike a partnership or sole proprietorship, they won’t be subject to self-employment tax, said Walker. “The savings would be on the payroll taxes (Social Security and Medicare taxes) on the difference between the salary paid and the net taxable income of the business that is subject to tax,” she said.
Other LLC Taxes
In addition to income tax, LLCs are subject to other federal, state, and local taxation.
Social Security and Unemployment Taxes
LLCs listed as sole proprietors or partnerships must pay a rate of 15.3% in self-employment taxes—including Social Security and Medicare—through the members’ personal returns.
Most employers have to pay 6% of an employee’s wages to federal unemployment taxes, as well as 6.2% to Medicare and Social Security benefits for each employee.
State by State
Since LLCs are designated by individual states, it’s critical for every LLC to consult their state and local laws when budgeting for taxes and fees.
Employers must pay state unemployment taxes, usually within the range of 2%-4% depending on where they operate.
While many states generally follow federal rules for taxing business entities, Foss said that some states have additional requirements. California, for example, imposes an $800 minimum franchise tax on all businesses. Meanwhile, states like New Hampshire and Tennessee do not recognize S-corp pass-through designations and so they are treated the same as C-corps.
Find out about your state business taxation policies through the IRS directory.
When To File Your LLC Taxes
Here are some important dates to remember in regards to specific LLC tax filings.
- Default partnership LLCs must fill out IRS Form 1065. These taxes are paid annually by March 15.
- Sole proprietors must include a Schedule C attachment on their standard Form 1040 tax return. These are estimated taxes that must be filed quarterly in addition to the annual taxes due April 15.
- For a corporation LLC, the business must report its income and deductions on Form 1120 annually and pay income tax. The deadline is generally the 15th day of the fourth month after the end of the corporation’s tax year, with certain exceptions. Each owner must also report their dividends on their personal Form 1040s.
- S-corporation taxes are due by March 15.
An LLC that wishes to change its default tax designation should fill out IRS Form 8832.