Limited liability companies, or LLCs, are popular business entities. Many families, friends, and married couples starting a business choose this type of structure for its simplicity and for the liability protections it offers. The taxation of multi-member LLCs, however, can be complex. Understanding the advantages of multi-member LLCs and how they are taxed can help business owners make informed decisions when forming a business.
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What are the advantages of forming a multi-member LLC?
Multi-member entities combine the flexibility typically associated with partnerships and the liability protection corporations enjoy. This arrangement means that individual LLC members are shielded from company debts, lawsuits, or other legal obligations.
Unless members have signed personal guarantees, their personal liability in those situations is generally limited to their business investments; their personal assets are generally protected and cannot be seized to satisfy company debts or other obligations.
Multi-member LLCs also enjoy flexibility when it comes to membership in or ownership of the company. A multi-member LLC may have as few as two members, but there is no upper limit to membership. In addition, members do not need to be U.S. citizens. In fact, even other LLCs or corporations can be members of a multi-member LLC.
How does the IRS treat multi-member LLCs for tax purposes?
By default, multi-member LLCs are taxed as general partnerships. As such, a multi-member LLC is a pass-through entity for tax purposes. That means the LLC business entity itself is not taxed, although it must file partnership tax returns with the IRS using Form 1065, which is considered an ‘information return.’
Rather than paying taxes at the company level, the profits or losses are passed through to the individual members – typically in proportion to each member’s share of ownership in the company.
What is the tax obligation of each individual member of a multi-member LLC?
As pass-through entities, multi-member LLC owners receive a Schedule K-1 each year to report the member’s share of company profits or losses. Each member’s distributive share is generally specified in the company’s operating agreement. In most cases, the distributive share of profits or losses mirrors or is tied to the member’s ownership interest in the business, but in some cases the distributive share could be higher or lower.
If the company made a profit during the tax year, each member may generally be responsible for taxes on their share of that profit – regardless of how much the member actually received as income from the business.
Because LLC members are not classified as employees, each member is also responsible for the self-employment tax, which represents both the company and employer portions of Social Security and Medicare taxes
Is there any way to change the way a multi-member LLC is taxed?
As mentioned above, the default tax approach for multi-member LLCs is as a partnership. Multi-member LLC owners may, however, opt to be taxed as an S-Corporation by filing IRS Form 2553 or as a C-Corporation by filing IRS Form 8832.
Choosing S-Corporation taxation does not change the pass-through taxation for the members of a multi-member LLC. However, LLC members who are active in the business may be treated as employees of the S-corporation, and compensated as such. If the corporation distributes dividend income to owners, such dividend distributions are generally not subject to the Social Security and Medicare tax requirements.
Electing C-Corporation taxation may make sense for some multi-member LLCs that retain significant profits within the company rather than distributing them. Retained earnings are generally not subject to the double taxation often associated with corporate taxes.
Explore Your Options and Make Informed Decisions for Your Business
Decisions about creating a multi-member LLC and about whether to opt for the default partnership tax treatment or to elect C-corporation or S-corporation status should be made only after consulting qualified tax and legal professionals. It is also important to note that the business and its members may also be subject to income tax at the state and local level. Consult with a Rocket Lawyer On Call® attorney for fast and affordable advice tailored to your business needs.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.