New tax clients and workshop participants who own a business often ask about their taxes when they have formed an LLC. My answer is, “It depends.” I realize that is not a satisfying response, but unless I know more about the business and its ownership, I cannot provide an accurate reply. It’s often the case that correctly answering tax questions depends a lot on your circumstances.
Here’s why. An LLC is a state-defined limited liability legal business structure. Business owners often form an LLC to protect their personal assets in case their business is sued. How an LLC operates for tax purposes has some default provisions and other options that primarily depend on the number of business owners.
An LLC can file business income taxes in one of three different ways:
- Sole Proprietorship
An individual business owner that has not incorporated is, by default, a Sole Proprietor. Sole Proprietors report income and expenses on a separate form filed with the owner’s individual income tax return, IRS Schedule C, “Profit or Loss from Business.” Net business profits are subject to income tax and the employer and employee portions of Medicare and Social Security taxes (i.e., 15.3% of net business profit).
- Partnership
Two or more individuals in business together without incorporating are, by default, a Partnership. Partnerships are considered a separate tax entity and are required to file a separate income tax return, IRS Form 1065, “U.S. Return of Partnership Income.” Partners receive an IRS Form K-1 for each one’s pro rata share of non-wage income and expenses, based on the operating agreement (a MUST).
- Subchapter S Corporation
Qualifying businesses can take the Subchapter-S election and avoid the double taxation of a C Corp. A number of rules apply to see if a business owner(s) qualifies. Sub-S Corps are considered a separate tax entity and are required to file a separate income tax return, IRS Form 1120S, “U.S. Income Tax Return for an S corporation.” Shareholders receive an IRS Form K-1 for their share of non-wage income and expenses, based on the operating agreement (again, a MUST). Owner/employees earn wages and get a W-2.
Determining how your LLC operates for tax purposes is not easy. It depends on the circumstances and many rules apply. Need more information? The IRS has you covered, as usual. Check out their tax information, tools and resources for business and self-employed individuals at https://www.irs.gov/businesses.