Do LLCs Have Double Taxation? How They Are Taxed
Understand LLC tax treatment. Explore how Limited Liability Companies typically avoid double taxation and their options for different tax classifications.
Limited Liability Companies (LLCs) are a flexible business structure in the United States, combining features of corporations and partnerships. They offer owners limited personal liability for company debts and actions, separating personal assets from business obligations. This balance of liability protection and operational simplicity makes LLCs appealing for various business sizes and industries.
Understanding Double Taxation
Double taxation refers to a tax system where the same income is taxed twice. This typically occurs in traditional C corporations. First, the corporation pays income tax on its profits at the corporate level. Currently, the federal corporate income tax rate is 21%. Second, when the corporation distributes its after-tax profits to shareholders as dividends, those shareholders then pay personal income tax on the dividends received. This effectively means the profits are taxed once at the company level and again at the individual shareholder level.
Default Tax Treatment for LLCs
By default, Limited Liability Companies are structured to avoid double taxation through “pass-through taxation.” Under this model, the LLC itself does not pay federal income tax on its profits. Instead, the company’s profits and losses are passed directly through to the owners’ personal tax returns. Owners then report and pay taxes on their share of the business’s income at their individual tax rates.
For a single-member LLC, the Internal Revenue Service (IRS) treats the entity as a “disregarded entity” for federal income tax purposes. The LLC’s income and expenses are reported directly on the owner’s personal tax return on Schedule C (Form 1040), Profit or Loss From Business. Profits are taxed only once, at the individual owner’s tax rate.
Multi-member LLCs are, by default, treated as partnerships for federal income tax purposes. The LLC files an informational return with the IRS, Form 1065, U.S. Return of Partnership Income. Each member receives a Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., outlining their share of the LLC’s profits, losses, and other tax items. Members then report these amounts on their personal Form 1040, ensuring profits are taxed only at the individual level.
Electing Corporate Tax Status
While LLCs typically enjoy pass-through taxation, they can elect to be taxed as a corporation. This election can alter their tax obligations, depending on whether the LLC chooses to be taxed as a C corporation or an S corporation.
If an LLC elects to be taxed as a C corporation, it does so by filing IRS Form 8832. This subjects the LLC to corporate income tax on its profits. Any profits distributed to owners as dividends would be taxed again at the individual level, leading to double taxation. This structure is sometimes chosen by businesses that plan to reinvest most earnings, seek venture capital, or eventually go public.
Alternatively, an LLC can elect to be taxed as an S corporation by filing IRS Form 2553. This election allows the LLC to maintain its pass-through tax status, avoiding corporate-level tax. Profits and losses pass through to the owners’ personal tax returns, but with specific rules regarding owner compensation. Owners who actively work for the business must pay themselves a “reasonable salary” subject to payroll taxes (Social Security and Medicare). Remaining profits, after the reasonable salary, can be distributed as dividends, which are typically not subject to payroll taxes.
Reporting LLC Income
The specific forms used to report LLC income depend on its tax classification.
When an LLC elects to be taxed as an S corporation, the LLC itself files Form 1120-S, U.S. Income Tax Return for an S Corporation. Owners receive a Schedule K-1 (Form 1120-S) from the S corporation, which reports their proportionate share of the company’s income, deductions, and credits. Owners then report these amounts on their personal Form 1040, and if they receive a salary for services performed, they also receive a Form W-2, Wage and Tax Statement.
If an LLC has elected to be taxed as a C corporation, the LLC files Form 1120, U.S. Corporation Income Tax Return, to report its profits and pay corporate income tax. In this scenario, owners only report income received as a salary, which is reported on a Form W-2, or as dividends, reported on a Form 1099-DIV, Dividends and Distributions. These amounts are then included on their personal Form 1040, reflecting the separate taxation of the corporation and its owners.