As Margaret Mitchell (author of Gone with the Wind) once said, “Death, taxes, and childbirth. There’s never a convenient time for any of them.”
But there’s a convenient time to learn how to file LLC taxes—like now for instance! Especially if you’ve recently started or are looking to start an LLC and don’t want to get into trouble with the IRS (Internal Revenue Service).
If you make mistakes on your personal tax returns and the IRS audits you, saying “I didn’t know I was liable” rarely cuts it. Actor Wesley Snipes tried that once and it didn’t end well; he got 3 years in prison. Yikes!
The point is, if you’re running an LLC, you need to know how to file LLC taxes.
And if taxes scare you a little or the idea of a pass-through entity has you scratching your head, don’t worry because I’ll explain what you need to know with as few complicated tax terminology as humanly possible.
An LLC is a “pass-through entity,” meaning the owners pay taxes while the entity itself does not. All profits and losses “pass through” to the owners (also called members) who report them on their tax returns, just like a sole-proprietorship or partnership.
Depending on how and where it’s operating and if it has employees, an LLC could be liable for other taxes, such as federal sales, payroll tax, and state tax. Some states also impose an annual tax on LLCs so that they can take a larger slice of your income pie!
Alternatively, LLCs can choose to register in a state with a zero annual tax bill, a lower tax rate, and lower registration fees. Here, your LLC would be viewed as a foreign entity.
And it gets better: If the pass-through entity tax system isn’t the most beneficial to your LLC, you can register as an S corporation instead, but more about that in just a minute.
LLCs have flexible structures, allowing you to choose from 4 different federal income tax classifications:
1. Single-member LLC: The IRS treats single-member LLCs as sole proprietorships for tax purposes. This classification falls into the “pass-through” taxation category, which means that the LLC itself does not pay taxes and does not have to file a return with the IRS.
As the owner of the LLC, you report business income or loss on the Schedule C tax form.
2. Multi-member LLC: The IRS treats multi-member LLCs as partnerships for tax purposes. Like single-member LLCs, multi-member LLCs don’t pay taxes on business income; instead, the LLC owners each pay taxes on their share of the profits on their personal income tax returns. Each LLC member’s share of profits and losses, called a distributive share, should be set out in the LLC operating agreement.
3. S corporation: An LLC can choose to pay taxes as an S corporation (also called an S subchapter) tax classification by submitting the IRS Form 2553. Here, profits aren’t subject to corporate income tax. Instead, LLC owners pay tax on their share of company profits, which aren’t subject to self-employment tax.
4. C corporation: When using the C corporation structure, the LLC’s profits aren’t subject to self-employment taxes, and the company pays payroll taxes on any wages paid to LLC members.
An LLC can choose to pay taxes as a C corporation by submitting IRS Form 8832, paying taxes on all profits at the corporate tax rate, and again on all dividends (distributed profits to owners) at the dividend rate (known as double taxation).
You’ll hear a lot of legal terminologies when learning about tax, one of them being “tax burden.” It’s the government’s way of saying the burden of tax compliance is on you!
As an LLC owner/member, you’re responsible for paying income tax on any profits taken from the LLC and self-employment taxes.
Self-employment tax refers to social security and Medicare taxes, charged at 15.3% of your net earnings.
As you’re self-employed, you’re required to file an annual return and pay an estimated quarterly tax based on your projected profits and losses.
The burden is on you to comply with providing accurate estimations, filing dates, payment dates, and any amendments.
Next up, a crash course in income tax:
The federal government and all but 7 states impose an income tax.
Federal government income rates are variable; i.e., the more you earn after pre-tax allowable deductions, the more you pay.
The federal income tax rates for 2021 are: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. All U.S. citizens pay federal income tax on total global earnings.
State income tax is dependent on income earned in that state, and there are 3 different rates in the U.S.:
1. Zero income: States such as Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming have a zero-income tax rate.
2. Flat tax: You pay tax on all income or dividends at the same rate. Dividends are regular payments of profit made to investors who own a company’s stock.
3. Progressive tax: Similar to federal tax, the more you earn, the more tax you pay.
But before you pack up and head for South Dakota or Tennessee to benefit from the zero-state tax rate, check out other state taxes, such as sales tax, property tax, and any other taxes or fees that might be higher than your home state.
The IRS doesn’t recognize LLCs as an entity.
That means there’s no LLC designated income tax form, but you still have to pay your taxes. The IRS ensures you do this by assigning a default tax status when registering your LLC entity with your state.
You can choose to pay taxes as a multi-member LLC (similar to a partnership), a single-member LLC (like a sole-proprietorship), or as a corporation (unlimited owners). A single-member LLC is most commonly known as a disregarded entity.
If you don’t choose, the government, by default, will tax you either as a sole-proprietorship or partnership based on the number of LLC members. Meaning you’ll pay tax as a pass-through entity.
A pass-through entity is also known as a flow-through entity or fiscally transparent.
Let’s look at what a pass through entity entails:
Pass-through entities are separate from the owner in terms of liability. Taxes “flow through” to the owner’s personal tax return, resulting in the members paying tax on their revenue, not on the LLC’s profits.
There are several advantages to using a pass-through entity business structure:
1. Avoiding double taxation: A major benefit of pass-through taxation is that business owners avoid double taxation. First, the income is taxed at the corporate level. Then, each owner’s income is taxed at the personal level. So the same income is taxed twice. That means your business’s earnings are only taxed once.
2. Reduced tax bill: Owners can benefit from a deduction on their tax bill if the business suffers a loss, as it’s usable to reduce overall taxable income.
3. Limited liability protection: An LLC has limited liability protection that prevents members from being held personally responsible for their company’s debts or financial losses. However, single-owner LLCs could be liable unless they create an operating agreement outlining the separation between themselves and the LLC.
4. Change business structure: You can register as a corporation if the need arises and back again.
As with all business structures, there are some disadvantages to pass-through taxation that you should know about.
1. Paying tax on unreceived profits: If LLC members decide to leave earnings in the company, they could be taxed for their share of the profits, resulting in being taxed on an income they didn’t receive.
2. Profit distribution: Unless an LLC’s members create an operating agreement that states the wage each member receives, distribution of profits could be restricted to each member’s percentage of ownership.
3. Rules change state to state: Each state has their own rules and regulations regarding the set-up and running of an LLC. These rules are called state bylaws, but you can bypass most bylaws by writing an operating agreement.
4. Self-employment tax: While LLCs avoid double taxation, owners might still have to pay self-employment tax; you can find out which taxes you’re liable for on your state’s website.
Anyone self-employed is required by the IRS to pay self-employment tax. As an LLC member, that means you.
Self-employment tax covers your Medicare and Social Security taxes; it’s a fixed rate of 15.3%. 12.4% of which is for social security and 2.9% for Medicare. You can figure self-employment tax yourself using Schedule SE (Form 1040 or 1040-SR).
If you change your business structure from LLC to an S or C corporation, you might not have to pay self-employment tax. The corporation pays payroll taxes on your behalf, similar to an employer, with taxes taken directly from your paycheck.
We’ll look closer at payroll taxes in just a minute.
But first, it helps if you know when you have to pay.
The U.S. operates a pay-as-you-go tax system, meaning you have to make income and self-employment tax payments throughout the year.
LLC members must pay estimated quarterly taxes on the following dates:
You can make payments using Form 1040-ES or online using IRS Direct Pay or the Electronic Federal Tax Payment System (EFTPS).
Always keep a record of any payments made because you’ll need to report them later on your tax return.
If you require more time to file your taxes, you can apply for an extension until the day your taxes are due.
You can request an extension using an “authorized e-file provider.” Single-member LLCs taxed as disregarded entities apply using Form 4868, while corporations and multi-member LLCs should use Form 7004.
Be aware that ignoring a deadline could cost you in several ways, including late filing fees, penalties, and if you poke the IRS hornets’ nest, they’ll audit you for good measure.
Most states are like the IRS in taxing LLC profits, with members paying tax on their personal tax returns.
However, not all states are alike; some add annual fees while others additional taxes.
Here’s what to look out for:
Some states charge an extra tax based on the amount of income the LLC generates, besides the income tax the members must pay on their dividends.
For example, California imposes an additional tax on LLCs that earn more than $250,000 per year.
Other states charge a yearly fee, also called a franchise tax, renewal fee, or annual registration fee.
The average annual fee in the U.S. is $91, but it varies from state to state. For example, California charges $800 “minimum franchise tax” but waives the fee for LLCs formed in 2021, 2022, or 2023.
It pays to do your research to determine if your state charges additional taxes or annual fees. You can find that information on the secretary of state’s website.
If your LLC has employees, it must collect and pay payroll taxes.
Payroll taxes cover your employee’s social security, federal and state unemployment, and Medicare taxes. As an employer, you share the cost of payroll taxes with your employee and withhold them (along with their income tax) from their paychecks.
The percentage you’ll pay as an employer depends on the size of your workers’ paycheck, tax rates, and where your LLC operates.
Both the employer and employee pay equal amounts; the rate for Medicare is 1.45%, and social security is 6.2%, meaning you each pay 7.65%.
You file payroll taxes using IRS Form 940 and Form 941. The IRS provides instructions for both forms to help you determine your deposit schedule.
You file Form 940 annually and use it to report your (as the employer) unemployment tax obligations.
You file Form 941 quarterly and use it to report any withheld income taxes and the employee’s and employer’s portion of Medicare and social security taxes.
Note: You don’t pay these taxes when filing the tax forms because of the IRS pay-as-you-go system for payroll taxes. Instead, you’ll need to deposit payroll taxes according to the IRS payment schedule.
You make a deposit using the Electronic Federal Tax Payment System (EFTPS).
I won’t lie to you, the U.S. tax system is confusing.
It’s because every state writes its own policies; some even have jurisdiction policies (in case it wasn’t confusing enough!). It’s almost enough to deter anyone from starting a business.
I said almost!
I’m going to break it down for you, starting with a tax that caught many e-commerce sellers out:
I swear sales tax nexus is one of those legal terminologies meant to confuse people. The word ‘nexus’ is a Latin word meaning to connect or link.
Sales tax nexus occurs when your business has some kind of connection to a state. Each state has a slightly different definition of nexus, but most consider that a physical presence or economic connection creates a nexus.
If you have sales tax nexus in a state, then you must collect sales tax from buyers in that state.
You’ll have a sales tax nexus in your registered state, but depending on how you’re doing business, you could have it in others, too.
You might have sales tax nexus in different states depending on these factors:
Determining your business’s nexus will tell you where to collect sales tax from, but, as mentioned, states collect tax in different ways. There are 2 methods for determining and collecting sales tax: Origin and destination based sales tax.
Origin-based sales tax means sales tax is collected based on the seller’s location. As a small business owner, that means you collect sales tax based on your state and local tax rates.
Destination-based sales tax means you charge the tax rate of where your service or product is going. That means you collect sales tax based on your customer’s state and local tax rates.
For example, If you’re based in California and your buyer is in Florida, you must charge the Florida tax rate.
Most tangible personal products are subject to tax, although states vary on which ones they choose to tax. But you probably guessed that by now, right?
For example, most states don’t charge sales tax on food items, but some such as Arkansas, Tennessee, Virginia, and West Virginia do.
Illinois imposes a 1% tax on grocery items and non-prescription drugs. In contrast, most other states charge a higher sales tax on non-prescription drugs.
Prescription drugs are exempt in most states except Illinois and Georgia who charge a reduced sales tax rate.
And if it’s clothing you sell, Pennsylvania has a zero-tax rate.
Each state decides which items are and are not taxable. To ensure you’re charging the correct tax, go to your state’s tax website and search for product tax rates.
You might be eligible for a sales tax certificate that exempts your LLC from sales tax when purchasing products you intend on turning into other products for resale.
You may be eligible for a sales tax exemption certificate only if your state belongs to the Streamlined Sales Tax Registration System. Go to your state’s revenue department to learn more information.
Remember: If you have a sales tax nexus in a state and your products are taxable in that state, you must register for a sales tax permit and collect sales tax from all buyers in that state.
Recall the burden of tax compliance I spoke about earlier in the post?
Well, as an LLC member, you’re responsible for setting aside an adequate amount of funds to pay taxes on your percentage share of profits.
And as you now know, you’re also required to make an annual tax estimate and make quarterly payments to the IRS and state tax agencies (if applicable).
Next, how to file your taxes as an LLC:
For tax, the IRS treats one-member LLCs equal to sole-proprietorships. Sole member LLCs report all losses and profits on the Schedule C tax form and then submit it with their 1040 tax return, including any funds remaining in your company bank account.
The IRS views multi-member LLCs as partnerships for collecting tax.
As with single-member LLCs, multi-member LLCs don’t pay taxes on their company income. Instead, the LLC members pay taxes on their share of company profits and file them on their income tax returns using the Schedule E tax form.
A member’s share of losses and profits is known as distributive shares and should be determined when forming the business in the LLC operating agreement. You can find further information on operating agreements in our article “What Is an Operating Agreement.”
Suppose you want to distribute profits and losses that are not proportionate to each member’s percentage interests (what they’ve invested) in the business.
In that case, it’s called a “special allocation,” and you must include it in the LLC’s operating agreement.
Nevertheless, the IRS treats all LLC members as if they’ve received their entire annual distributive share, regardless of how profits are divided.
So, even if members leave profits in the LLC to expand the business or pay for new stock, the IRS’s rule is that each member is liable for income tax on their total rightful share.
A multi-member LLC must file a Form 1065 with the IRS, as it enables the IRS to ensure that all members are correctly reporting their LLC income.
An LLC must provide each member with an annual Schedule K-1 tax form, which shows each member’s percentage share of all profits and losses.
Each member must then complete their individual income tax return using the Schedule E 1040 Form to report their profits and losses.
And that, my friend, is pretty much all there is to know regarding how to file LLC taxes.
But what if you’re not happy with the tax requirements of an LLC? In this case, you could choose corporate tax status; I’ll explain next:
You might choose a corporate taxation status if you keep large amounts of company profits, known as “retained earnings,” in your business.
You’d do this because C corporations pay tax at a flat rate of 21%, which is less than the tax rates (ranging from 32% to 37%) that LLC owners pay at various income levels.
If you choose a corporate tax status, you file the IRS Form 8832 (Entity Classification Election) and check the corporate tax treatment box on the form.
But remember, a C corporation is liable to double taxation on any profits (dividends) paid to members. The result is you’ll pay 21% corporation tax and then up to 23.8% on any wage you receive.
There is a silver lining, though. You can avoid double taxation by leaving profits (“retained earnings”) in the business.
Choosing corporate tax also affords owners and employees other tax fringe benefits, such as stock ownership plans and stock options. All of which aren’t subject to double taxation.
Death, taxes, and childbirth, always inconvenient and usually painful!
But I hope this article has helped relieve some of the pain from filing your LLC taxes. And remember, the secret to a long happy relationship with the IRS is timely compliance, knowing your liabilities, and which tax forms to submit.
An experienced tax accountant can help you with those. As for death and childbirth, I’m afraid you’re on your own.
This portion of our website is for informational purposes only. Tailor Brands is not a law firm, and none of the information on this website constitutes or is intended to convey legal advice. All statements, opinions, recommendations, and conclusions are solely the expression of the author and provided on an as-is basis. Accordingly, Tailor Brands is not responsible for the information and/or its accuracy or completeness.
Products
Resources
@2024 Copyright Tailor Brands