LLCs are great because they are flexible when it comes to determining how you want to be taxed. You have the option of taxing your LLC like a sole proprietorship, a partnership or a corporation by filing the appropriate forms with the IRS.
Let's talk about the default way your LLC will be taxed, how your LLC Operating Agreement can give you further control, what forms you should file, and lastly, how to change your tax identity if you so choose.
If I Do Nothing, How Will My LLC Be Taxed?
The IRS will automatically classify your LLC as either a sole proprietorship or a partnership depending on how many members (owners) the LLC has. If you are the only member in your LLC then the IRS will tax your LLC as if it were a sole proprietorship. If there are more than one members in your LLC, the IRS will treat it as a partnership.
As we mentioned above, an LLC defaults to a "pass-through entity." This means if your LLC makes $20,000 profit, you're paying the taxes on your share of that profit in your personal tax return. So, say your LLC has four partners with an equal share of the company. You'll each pay the taxes on $5,000 profit. If your LLC is yours and yours alone, you'll pay those taxes on your 1040 tax return.
What Forms Should I File?
Every LLC should have an Operating Agreement (you can read more about that here.) While most states do not require an operating agreement, it is advisable to create one. Operating agreements are essentially contracts between the members of LLCs outlining the structure of the business, including - for our purposes - the business's tax structure. Be sure to check if your state requires that you file your operating agreement.
Past that, you'll need to file Form 1065 with the IRS. The IRS uses this to ensure each LLC member is properly reporting their income from the LLC. You should also give each member a Schedule K-1 so everyone has, in writing, their share of the profits and losses.
After this, every member of the LLC will be taxed personally on their 1040 tax return.
How Can I Change My LLC Tax Identity?
Some LLCs elect to be taxed as corporations (like a C-Corp or S-Corp). But why? The most common reason is that their business wants to keep a hefty amount of their profits in their LLC and these so-called "retained earnings" are generally taxed at a lower rate than they would be on a personal 1040 tax return.
To elect corporate taxation, you'll have to file an "Entity Classification Election" (IRS Form 8832.) On it, there should be a section in which you can elect to be taxed as a corporation. If you choose to be taxed as an S-Corp, you will also need to file IRS Form 2553 "Election by a Small Business Corporation."
What Else Do I Need to Know?
Here are a few more items you might want to keep in mind.
- Since LLC members aren't technically employees, and since you may be taking these earnings out of your personal tax return, remember to set some profits aside come tax time.
- Likewise, your Social Security taxes and Medicare taxes may not be taken out on a paycheck to paycheck basis.
- Last of all, please remember that LLC laws in each state are different. Some states may tax your LLC in different manners. Consult with an experienced business attorney or accountant for the rules in your locality.
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.