You might expect your tax situation to drastically change after you form a limited liability company (LLC). Turns out, that’s not always the case.
“I find the main thing that’s hard to get across to people is that an LLC isn’t a tax designation,” says Russell Garofalo, founder of Brass Taxes. An LLC is a business entity that’s formed at the state, not federal, level.
When it comes to filing and paying taxes, the rules that apply to your LLC can depend on how many owners (called members) are part of the LLC, how the IRS classifies your business, and how you chose to classify your LLC.
Your LLC’s classification can also change over time.
For example, you might start an LLC with a partner, leading to a partnership classification. But if you buy your partner’s stake and become the sole member, the LLC might become a disregarded entity. Or, you may start an LLC and by default leave it as a disregarded entity. Then, once you start making more money decide you want to be classified as an S Corporation.
You can generally opt to change your LLC’s classification every 60 months, and the classification you chose or were assigned when you formed the business doesn't count as a “change.”
Here’s a more in-depth look at how the tax filing process can vary depending on your LLC’s classification.
If you’ve been operating your business as a sole proprietor, you’re the only member of your new LLC, and you don’t elect a corporation classification, the tax filing process may be nearly identical to what you’ve done in the past.
“Single-member LLC owners file their taxes right on their personal taxes with a Schedule C,” says Garofalo. “It’s the same as if you were a freelancer or made some 1099 [consulting or freelance] income.”
The Schedule C is where you’ll add up your LLC’s income and deduct your business expenses. The net profits or losses will carry over to your Form 1040, your personal tax return form.
You’ll also need to pay self employment taxes on your LLC’s profits if you made at least $400, although this is also the case if you are a sole proprietor without an LLC.
By default, the IRS considers most LLCs with more than one member partnerships.
Partnerships have to file Form 1065, an information return, by March 15th. The LLC itself doesn’t pay taxes, but it reports relevant information (such as income and expenses) to the IRS and issues each member a Schedule K-1.
Your K-1 should have your portion of the LLC’s activity (profits, losses, credits, deductions, etc.). For example, say your LLC had $125,000 in revenue last year and $25,000 in business expenses. If there are four partners and each was entitled to 25 percent of the profit, each partner would receive $25,000.
You’ll then have to include your portion of the income (or losses, if that’s the case) when you file your personal tax return on a Schedule E. If you’re an active member of the LLC — versus being an owner who doesn't work in the business — you may have to pay self-employment taxes on your share of the earnings.
With a C corporation designation, the LLC will have to file its own tax return (Form 1120) by the same date as you’d file a personal tax return (if it uses the calendar year as its tax year).
An LLC electing to be treated as a C corporation is a completely separate entity from the owner, and it pays its own income taxes when it files a tax return. As an employee of the company, you may receive a W-2, just like if you were an employee of any other company. An LLC with C corporation classification can also choose to distribute money to its owner by issuing a dividend, which is reported on Form 1099-DIV.
The LLC C corporation may be able to deduct your wages as a business expense, but could have to pay income tax on the money that’s distributed to the owners via dividends. As a result, you could wind up paying taxes on earnings twice — once when the corporation earns the money and again when you report your dividend income on your personal return.
LLCs that are designated as S corporations must file an informational return (Form 1220S) by March 15. An S corporation LLC is a pass-through entity, similar to a disregarded entity or partnership, and doesn’t pay its own taxes.
You can get money from your LLC S corporation as both an employee and owner. As an employee, you’ll get paid via payroll (which is also a business expense for the LLC). You’ll get a W-2 for this portion of your income.
LLC S corporations also have to pass their profits on to shareholders each year via distributions. As an owner, you’ll receive a K-1 for your portion of the profits. Unlike with a partnership, you don’t have to pay self-employment tax on the distributions, but you’ll still have to include them on your personal tax return and pay income tax on the money.
Forming an LLC isn’t necessarily difficult. However, choosing a new classification for your LLC could have serious tax and operational impacts on your business. You should consult a tax attorney and/or accountant who understands your industry, is familiar with your local tax laws, and can advise you on the pros and cons before proceeding.
Even after you’re set up, you may want to hire a tax preparer to help you file your personal or business tax return. “I don’t think everyone should see a tax preparer,” says Garofalo, “but if you’re in the gray area of reporting business expenses, that’s when it makes sense.”
If you decide to hire a professional, interview several prospects before making a decision. “Just because someone is a CPA doesn’t mean they know what you do,” says Garofalo.
An average business owner, especially one who is just starting out, may not know which expenses are deductible. The preparer should understand your industry and be willing to have a discussion about your business. “The back-and-forth can help the tax preparer discover what’s a valid business expense and what isn’t,” says Garofalo. As a result, you may be able to save money by taking more deductions — or save time and money by avoiding an audit.
Funding Circle believes informed consumers are better consumers. We strive to provide informative and educational content useful for you and your business. However, please note that tax laws and regulations are complex and subject to change. We strongly recommend consulting your financial or tax professional regarding your specific circumstances.