There is a good reason for the LLC’s popularity as a structure. Unlike corporations, this entity type is granted significant tax benefits based on its classification. The default treatment of such companies is similar to informal structures, meaning that they are exempt from certain tax duties like the federal income tax. However, their cross-cutting status entails a different set of obligations, which can be confusing to aspiring entrepreneurs, especially when paying taxes. The purpose of this article is to examine each of these taxes in more detail.
How LLCs Pay Income Taxes
The extent of duties placed on an entity by the IRS largely depends on its type. Aside from the main classification as a limited liability company that falls under the general umbrella of pass-throughs, an entity in this category can also be defined by its internal structure, specifically how its ownership and management are handled.
The more intricate details of your tax responsibility are determined by the number of individuals engaging in the operations, as well as the voluntary election of another tax classification. More on each of these subtypes below.
An entity labeled to have limited liability but owned and run by one individual is considered a single-member LLC whose tax duty coincides with that of a sole proprietorship as far as the IRS is concerned. This exempts the enterprise from federal income duty, but instead, the owner records all profits and expenses incurred in the course of the entity’s activities as part of their personal return using Schedule C (Form 1040 or Form 1040-SR for owners over 65). The standard deadline is April 15.
The classification of limited liability entities with more than two members follows similar logic as with sole owners. Except, in this case, these companies are regarded as partnerships when it comes to filing procedures. Again, this means that as a whole, the entity isn’t required to follow federal income taxation rules.
That said, the company is still expected to submit Form 1065 to inform the IRS of its financial activities. Following that, the members receive a Schedule K-1 form each. Then, they file the entity’s actual profits and losses on personal returns using Form 1040. Tax duties are calculated based on each member’s distributive share outlined in the operating agreement. The default deadline is March 15.
Another option available to the owners is to choose another form of taxation, specifically that of a C-corporation (Form 1120) or S-corporation (Form 1120S). This can technically be done at any time, but many entrepreneurs decide to do it during the formation. Either way, the new system becomes effective when the IRS approves your Form 8832 or at the date provided in the application. Note that despite the C-corp’s 21% rate being significantly lower than the personal 32%-37% rate, the former falls under the double taxation rule, meaning that you pay both on the total income and then on your individual share after distribution, this time at a capital gains rate.
In place of withholding taxes typically applied to wages, members have to compensate for it in a more direct fashion by way of the SECA tax filed on Schedule SE. It’s imposed on each individual portion of profits except for the members that do not provide any paid services and are instead listed as investors rather than any managing power. The first $137,700 in earnings is taxed at the rate of 15.3% consisting of 12.4% for social security and 2.9% for Medicare. Any yield above the threshold gets an additional 2.9% for Medicare and another 0.9% on income over $200,000.
Expenses and Deductions
Another way to minimize the amount of tax you pay on your total earnings is by making deductions on operational expenses. They must be legally sound, traceable, and have clear records for reviewing at a later date. The type of things you can classify as legitimate write-offs may vary depending on the industry and sometimes, location. In general, however, the most common deductions among small businesses are:
- Transportation and parking;
- Rent (office spaces, warehouses, etc);
- Licensed software;
- Donations to nonprofits;
- Entity’s property (only the first year);
- Initial training and skill development;
- Professional service fees (banks, accounting, consulting, tax, contractors, etc);
- Advertising and market research;
- Catering and gifts;
- Conferences, club membership, seminars.
Certain entities might also apply for the TCJA tax credit program, allowing owners to deduct up to 20% on the total income. The maximum threshold is adjusted annually for the purposes of inflation. If you stay below this figure, you are free to write off that 20%, but if your earnings are above the top margin, you can only deduct a certain percentage on specific payments such as 50% of total wages paid. Some professionals can’t qualify for this program. It’s also not applicable to entities with C-corp tax systems.
LLC Payroll Taxes
All entities that retain regular workers (rather than taking on one-time contractors) automatically qualify for payroll taxes. They consist of:
- Unemployment tax at the rate of 0.6% on the first $7,000 of wages;
- Social security at the rate of 12.4%;
- Medicare at the rate of 2.9% (with a 0.9% surtax for wages exceeding $200,000).
The first item on the list is designed to provide continuous support for insurance relief programs. The other two are commonly known as FICA taxes and apply to employers and workers in equal measure, except unlike with SECA, the employer has to subtract these taxes from the intended wages before paying them.
To cover the unemployment portion of the tax, the employer must submit Form 940 each year before January 31 with the actual payments delivered during each quarter. In contrast to this annual filing, the FICA portion of the tax follows a special schedule. The form itself (Form 941) implies quarterly filings with the payments made on a monthly basis or twice a week. You can do it digitally using the EFTPS. To learn more about the procedure and how it relates to your entity, consider looking through the IRS forms or consulting a professional accountant.
State Taxes and Fees
In the vast majority of states, this entity type follows the same rules in regards to its pass-through classification, meaning that the owners report the company’s income on individual returns rather than pay the tax on the overall profits. However, some jurisdictions implement other forms of tax based on the industry of involvement, size of the enterprise, and location within the state.
Other taxes: Some states levy additional taxes on specific entities based on their income. For instance, Minnesota applies the so-called partnership tax, while California companies with annual revenue exceeding $250,000 may be required to pay quite a steep sum in fees.
Sales tax: Almost any entity that provides goods and services for profit is subject to sales tax within its jurisdiction. There are only five states that don’t have statewide sales taxes but still employ them locally. Even if you don’t have a shop or manufacturing facility set up in a specific jurisdiction but still deliver goods to that destination, you will be obligated to pay the sales tax. Not all states impose this tax based on the destination, but it’s safe to say that the majority of them do.
Maintenance fees: A considerable number of states charge for the privilege of operating a for-profit entity. The name for this charge varies, with some states referring to it as franchise tax and others going for less intimidating renewal/registration fee. The annual charge ranges from $100 to a whopping $800 in California.