When an LLC is created in any state, a selection is permitted for how the business is taxed by the federal government. This choice affects the accounting records and type of tax return required for the LLC.
Most importantly, the decision about federal tax status impacts how income tax is determined. Depending upon the amount of business income, the right tax status election can significantly reduce the tax burden on the LLC.
The Internal Revenue Service assigns default tax status to a new LLC if the members of the LLC do not select an alternative. The IRS automatically taxes an LLC with only one member as a sole proprietorship. An LLC with multiple members is automatically taxed as a partnership.
By filing Form 8832 with the IRS, an LLC with any number of members may elect tax status as a corporation rather than the automatic default. There is a distinctive accounting burden for corporations. A bookkeeping system is required that provides an accurate balance sheet and capital account, which must reconcile for one year to the next on federal income tax returns. But the extra accounting effort required of corporations can provide worthwhile advantages due to potential income tax savings.
Depending upon the amount of taxable profit for the LLC, the tax rates for a corporation may be lower than individual tax rates.
The profit of a single-member LLC taxed as a self-employed proprietor is reported on the member’s personal federal income tax return. Income tax is calculated at the graduated rates for personal income tax. In addition, the LLC profit is subject to the same self-employment tax as a proprietor that did not form an LLC. Therefore, a single-member LLC taxed is referred to as a “disregarded entity” for federal income tax purposes if the profit is taxed like a proprietorship.
Profit of an LLC taxed as a partnership is reported on a separate income tax return. However, the income tax is paid when each LLC member reports his respective share of profit on his personal income tax return. Income tax at personal rates plus self-employment tax is calculated and paid with the personal income tax return of each member.
For an LLC taxed as a corporation, profit is reported on a corporation tax return. Tax is calculated at corporate tax rates—which are different than personal rates—and paid by the corporation. The LLC members are not taxed personally except for wages or dividends they receive from the LLC.
An LLC taxed as a corporation may elect S corporation status by filing Form 2553 with the IRS. In this case, the LLC files a tax return but doesn’t pay income tax on the profit. Instead, members report their portions of profit on their personal income tax returns, just like a partnership. But no self-employment tax is assessed on the profit of an LLC taxed as a corporation. However, there is an assessment of employment taxes on wages paid to a member, just like any employee of a corporation.
Sometimes spouses are the only LLC members and both materially participate in the business operation. In this case, they may elect tax status as a corporation, partnership, or two separate proprietorships.
They must file the appropriate form to elect tax status as a corporation. If they elect tax status as a partnership, a separate tax return is required annually for the LLC. Instead of filing a partnership tax return, the spouses may file as two separate proprietors. The revenue and expenses of the LLC are divided according to ownership proportion. Two separate taxable profits are determined and each spouse pays income tax and self-employment tax on respective shares of profit. They can still file a joint tax return, which simply shows the LLC as if it were two different businesses.
These considerations are important at the time of forming your LLC in any state. To get the advice of your CPA is important to avoid potential problems.