How Your Small Business LLC Can Be Taxed

Sole proprietorships are the most common business type, but creating an LLC might lead to tax savings for your small business.

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Many business owners choose to start their businesses as limited liability companies (LLCs) because the business structure offers certain legal and financial protections.

LLCs also offer business owners more flexibility in how they're taxed.

When you create an LLC, it's automatically taxed as a sole proprietorship or as a partnership, depending on the number of owners, called members.

However, you have options. You may change your LLC's federal tax classification to either an S corporation or a C corporation. The best tax treatment option maximizes your tax savings when you file your small business taxes.

How single-owner LLCs are taxed

Single-owner LLCs are 100% owned by one person or, depending on the state, one married couple. By default, they're taxed like sole proprietorships.

Sole proprietorships

Sole proprietorships are a type of pass-through business where the business pays tax on profits through your personal tax returns. Standard single-owner LLCs file no separate business tax return, so they're called a disregarded entity.

If taxed as a disregarded entity, your LLC pays you a "draw," not a salary or wage. The amount you draw from your business doesn't generally impact your tax liability because taxes are based on earnings, not the amount you take home.

S corporations, another type of pass-through business, function nearly the same, but they have a key difference: Owners of S corporations who actively work in the business are considered employees, and owners of disregarded entities are not.

What does that mean? Potentially, tax savings. But more on that later.

S corporations

Businesses taxed as S corporations file an information return, Form 1120-S. Even though they only pay tax through their owners, LLCs taxed as S corporations must inform the IRS of earnings each year. For that reason, they're not called a disregarded entity.

To get your LLC taxed as an S corporation, you need to ask the IRS to consider it a C corporation first. From there, you can request a second change to the S corporation designation with Form 2553.

Not all LLCs can be treated as S corporations. Check the IRS notice on S corporations to see if your small business is eligible.

C corporations

The C corporation tax designation adds separation between you and your business: C corporations file and pay their taxes separately from their owner or owners. They're not a pass-through business type.

C corporations pay 21% on taxable income, and owners are generally considered employees. Again, more on what that means later.

Only 21%! Why doesn't every LLC get taxed as a C corporation?

Double taxation. And a lot more paperwork.

While your business pays 21% on taxable income, you're essentially paying tax twice on any income you receive aside from your salary, like dividends. Dividends are not a business tax deduction and are included in both your business's and your personal taxable income.

Also, C corporations come with a lot more rules, like additional required tax filings. It's not a suitable tax designation for most small businesses.

How multi-owner LLCs are taxed

At formation, multi-owner LLCs are automatically taxed like partnerships. Partnerships are pass-through entities, just like disregarded entities and S corporations.

When taxed as a pass-through entity, multi-owner LLCs distribute earnings to each member based on an agreed-upon profit-sharing percentage.

Owners of LLCs taxed as partnerships take draws to pay themselves, just like disregarded entities.

The percentage of the LLC that you own, called your ownership interest, is normally the same percentage of profits that you report on your personal taxes. LLCs can change their profit-sharing percentages while maintaining ownership interest if they let the IRS know.

Though the standard multi-owner LLC pays tax through its owners, the LLC files Form 1065, an information return that details earnings.

For example, let's say an LLC with three members reports $300,000 in taxable income on Form 1065. Let's calculate each member's taxable income:

Member Ownership Interest Share of Income
1 20% $60,000 ($300,000 * 20%)
2 30% $90,000 ($300,000 * 30%)
3 50% $150,000 ($300,000 * 50%)

Each member's taxable income is not necessarily the same as his or her draw. Draws don't usually affect members' tax liability because members are responsible for paying tax on their income share, not just the amount of their draw.

Multi-owner LLCs with an S corporation tax designation distribute earnings among members the same way as LLCs taxed as partnerships. The owner's wages are treated differently because S corporation owners are considered employees. The S corporation files an information return with Form 1120-S.

Multi-owner LLCs taxed as C corporations are subject to the 21% corporate tax rate. Each member reports and pays tax on his or her salary earnings.

How LLCs as a pass-through business are taxed

LLCs treated as pass-through businesses — disregarded entities, partnerships, and S corporations — pay tax through their owner or owners.

Let's say you're the only owner in an LLC that provides landscaping services. Last year, you had taxable income of $100,000, and you paid yourself $50,000.

As a disregarded entity, you report $100,000 of income to your self-employment tax software. Even though you only paid yourself $50,000, you're responsible for paying tax on the business's entire taxable income.

Multi-owner LLCs treated as a partnership pay tax similarly.

Four brothers agree to be equal members at LLC registration. The business has $500,000 in taxable income, and each got paid $75,000.

Taxed as a partnership, each brother reports one-quarter of business profits on his Form 1040. Each brother enters $125,000 ($500,000 divided by 4) of income on his Form 1040. Their $75,000 draws are irrelevant because they pay tax according to business earnings.

S corporations are taxed the same way in both examples, but the calculation of taxable income changes.

How to write off LLC business expenses and deductions

In general, LLCs of any tax designation write off expenses and deductions just as other small businesses. Check out our guides to small business tax deductions.

Where LLC tax classifications diverge is the owner's income from the business.

S corporation owners who actively participate in the business are employees, which means they must be put on the payroll and paid a salary or wage, which is subject to payroll taxes like Medicare, Social Security, and FUTA taxes.

What's special about S corporations? Any leftover earnings are considered distributions that are not subject to payroll taxes.

But, don't try to fool the system by making your business an S corporation and only paying yourself in distributions to avoid employment taxes: IRS Publication 535 requires that you pay yourself a "reasonable" salary.

Owners of other pass-through businesses — disregarded entities and partnerships — aren't considered employees, and they're required to pay self-employment taxes on their share of the LLC's earnings, even if they didn't remove the money from their business's account.

Let's look at a few examples.

Consider an LLC with two equal members and $500,000 in income.

LLC Taxed as... S Corporation Partnership
Earnings before member’s pay $500,000 $500,000
Member salaries $400,000 ($200,000 per member) n/a
Member distributions $100,000 ($500,000 - $400,000) n/a
Amount subject to payroll tax and income taxes $400,000 $500,000
Amount subject to income tax, not payroll tax $100,000 $0

Since partnership and disregarded entity owners cannot take salaries, their entire income is subject to payroll taxes. The money they take home, called a draw, generally does not affect their tax liability because they owe tax on all company earnings, whether the earnings are still in the business or their personal accounts.

Let's see what happens when there's no leftover profit:

LLC Taxed as... S Corporation Partnership
Earnings before member’s pay $400,000 $400,000
Member salaries $400,000 ($200,000 per member) n/a
Member distributions $0 ($400,000 - $400,000) n/a
Amount subject to payroll tax $400,000 $400,000
Amount not subject to payroll tax $0 $0

The S corporation tax classification benefits businesses that earn significantly more than their owners' salaries. Businesses that are closer to the break-even point are better off sticking with the standard LLC tax designation. (Whew. I know — we're almost done!)

Additional taxes for LLCs

In most states, LLCs and their owners pay tax just like any other company or person would. Pass-through businesses pay no tax, but their owners will pay tax on their share of their business earnings.

Some states charge a special tax on LLCs that earn more than a certain amount in net income, and a slew of states make LLCs pay an annual fee, usually less than $1,000.

Before you create an LLC for your side business, take a look at your state's rules on LLCs, because these taxes and fees might sink your profit.

Run the numbers

When choosing the right tax designation for your LLC, look to your past earnings and calculate your tax liabilities under each classification. Review your business budget for next year and run the same calculation.

Your LLC's tax designation determines your small business bookkeeping practices. If you make a change, consult an accountant to get your books back on track.

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