Do Delaware LLCs Pay Taxes? Federal vs. State Explained

Limited Liability Companies (LLCs) are a popular business structure, chosen for the liability protection they offer their owners. A common misconception is that forming an LLC in Delaware provides a blanket exemption from state-level taxation, regardless of where the business operates. Understanding the various layers of taxation that apply to an LLC, irrespective of its state of formation, is important for any business owner.

Delaware’s State-Level Taxation of LLCs

Delaware does not impose a state corporate income tax or personal income tax on LLCs themselves, provided the entity is structured as a pass-through for federal tax purposes. This absence of income tax at the state level can lead to misunderstandings about overall tax obligations.

However, all domestic and foreign LLCs formed or registered in Delaware are required to pay an annual franchise tax. This annual fee is currently $300.00. The payment for the prior year’s annual tax is due on or before June 1st. Failure to pay this required annual tax results in a penalty of $200.00, plus 1.5% interest per month on the tax and penalty.

This annual tax is distinct from an income tax and serves as a fee for maintaining the LLC’s legal existence within the state. It is not based on the LLC’s income or profit. The payment ensures the entity remains in good standing.

Federal Income Tax Treatment for LLCs

The Internal Revenue Service (IRS) taxes LLCs based on elections made by the entity and the number of its members. An LLC is not a recognized tax entity on its own for federal income tax purposes; instead, it adopts a tax classification. The default classification depends on the number of owners, though an LLC can elect to be taxed differently.

For a single-member LLC, the default federal tax classification is a “disregarded entity,” meaning it is treated as a sole proprietorship. In this scenario, the LLC’s income and expenses are reported directly on the owner’s personal tax return, Form 1040, using Schedule C, Profit or Loss From Business. This simplifies tax reporting as the business’s financial activity flows through to the individual’s return.

A multi-member LLC is, by default, classified and taxed as a partnership for federal purposes. As a partnership, the LLC must file Form 1065, U.S. Return of Partnership Income. Each partner then receives a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., detailing their portion of the LLC’s profits or losses, which they report on their individual Form 1040.

An LLC also has the flexibility to elect to be taxed as a corporation, either a C corporation or an S corporation. To be taxed as a C corporation, the LLC must file Form 8832, Entity Classification Election, and subsequently file Form 1120, U.S. Corporation Income Tax Return. Alternatively, an LLC can elect S corporation status by filing Form 2553, Election by a Small Business Corporation, and then file Form 1120-S, U.S. Income Tax Return for an S Corporation. These elections change how the LLC’s profits are taxed at the entity level, offering different tax implications for the business and its owners.

Taxation in Other States of Operation

Forming an LLC in Delaware does not automatically exempt it from tax obligations in other states where it conducts business activities. A Delaware LLC will be subject to taxes in any state where it establishes “nexus.” Nexus refers to a sufficient physical or economic presence within a state that triggers tax jurisdiction.

Physical presence can be established through various activities, such as having employees, physical offices, warehouses, or inventory. Even maintaining a small office or having a single employee can create nexus, obligating the LLC to comply with that state’s tax laws. The concept of economic nexus has also expanded, meaning a business can establish nexus based on a certain volume of sales or number of transactions within a state, even without a physical footprint.

Once nexus is established, the Delaware LLC may be subject to a range of taxes in that state. This can include state income taxes, state-level franchise taxes (which differ from Delaware’s annual fee), sales taxes, and other local taxes or fees. For example, if a Delaware LLC sells goods to customers in another state, it may be required to collect and remit sales tax if it meets that state’s economic nexus thresholds. Compliance with the tax laws of all states where an LLC has nexus is necessary to avoid penalties and maintain good standing.

Taxation of LLC Owners

The “pass-through” nature of LLCs, when taxed as disregarded entities or partnerships, means that the business’s profits and losses are not taxed at the company level. Instead, these amounts are passed through directly to the owners. Owners then report their share of the LLC’s profits or losses on their personal income tax returns, specifically on Form 1040.

Active members of an LLC are generally subject to self-employment tax on their share of the business’s net earnings. This tax covers Social Security and Medicare contributions. The self-employment tax rate is 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare. This tax applies to net earnings from self-employment exceeding $400.

LLC owners calculate their self-employment tax using Schedule SE, Self-Employment Tax, which is filed with their Form 1040. They can also deduct one-half of their self-employment tax in figuring their adjusted gross income, which reduces their overall income tax liability. Distributions received by owners from an LLC are generally not subject to further income tax if the income has already been included in their taxable income through the pass-through reporting.