How Are LLCs Taxed?
One of the biggest questions that potential business owners ask is: “How will my LLC affect my taxes?” The answer largely depends on choices you must make regarding how you would like your LLC to be taxed.
The IRS taxes LLCs in a couple of default ways, but the LLC can opt to deviate from the norm if it betters serve the needs of the business. The Illinois Department of Revenue (“IDOR”) will treat the business the same way as the IRS.
While it is important to always (always!) discuss tax options with an accountant, understanding the different ways an LLC can be taxed will help you enter that conversation prepared.
Single-Member
By default, the IRS taxes a single-member LLC as a sole proprietorship for income tax purposes only. This means that the LLC’s income will “pass through” to the owner and will be included on the owner’s personal income tax forms. For this reason, a single-member LLC is classified as a “pass-through” entity. The owner pays the company’s taxes on their individual return; no special form for the business needs to be filed. Be aware, though, that the owner will have to pay self-employment taxes as well.
Multi-Member
The IRS taxes a multi-member LLC as a partnership by default. Like single-member LLCs, partnerships are taxed on a pass-through basis. The entity itself is not taxed; rather, the members of the LLC are taxed on an individual level.
The IRS requires that the LLC file a “U.S. Return of Partnership Income” form, which must be signed by an official member. This form discloses the LLC’s income for the prior fiscal year and breaks down how the income will be split between its members. Income, losses and gains can be distributed between the members as they see fit. The member managers must then include their share of the LLC’s income on their personal tax returns, where it will be treated as personal income. Each member manager who is active in the business must also pay self-employment taxes.
If the IRS treats the LLC as a partnership (again, this is the default classification), IDOR requires that the business file an “Illinois Partnership Replacement Tax Return” form (instructions on using the form, which is rather complex, can be found here). The individual members will then need to file a Schedule K-1-P (instructions here), which includes the amounts “passed through” to their Illinois income tax return.
Changing the Default: S-Corp or C-Corp Status
If single-member or multi-member taxation doesn’t appeal to the business owners, they can make a special election to have their LLC taxed as either an S-Corp or a C-Corp.
C-Corps are subject to double taxation, which means that the entity itself is taxed; after the income is distributed, the members are also taxed individually. In a C-Corp, the basic type of corporation, shareholders own the business and directors run the business. If the LLC elects to be taxed as a C-Corp, the LLC itself will taxed on its income and then the members will be taxed on distributions they received from the LLC. C-Corps are taxed per Subchapter C in the IRS tax code.
S-Corp taxation lets the income and losses pass through to the owners of the business. The members are taxed on their allocated share of the income, gains and losses, rather than what the members actually received. The members do not need to pay a self-employment tax if they are involved in the management of the business. S-Corps are taxed per Subchapter S in the IRS Tax Code.
If one of these structures interests you, remember: always consult an accountant when deciding whether or not to change the LLC’s default tax structure.
LLCs’ flexibility extends beyond taxation – they can be set up and run (almost) any way you like. When forming an LLC, the owner can choose who runs the business, whether it’s a manager or the members, and how the business operates. All this information, in addition to details about equity and capital contributions, are contained in the LLCs operating agreement.
When starting your business, find an attorney to help find the appropriate entity type, draft a strong operating agreement, keep your liability limited, and make sure that your company’s tax structure is working for you.