How Much Are LLCs Taxed? Federal & State Taxes

An LLC offers a flexible business structure that provides owners with liability protection and various taxation methods. Unlike traditional corporations, the IRS does not impose a single default corporate tax structure. Instead, an LLC’s taxation depends significantly on the number of owners and specific elections made with the IRS. This adaptability means an LLC can be taxed in several ways at the federal level, and it also faces state and local tax obligations that vary by jurisdiction. Understanding these diverse tax treatments is important for any LLC owner.

Understanding Default Federal Income Taxation

By default, the IRS classifies an LLC based on its number of members, which dictates its initial federal income tax treatment. This approach ensures that the business’s profits and losses are taxed at the owner level rather than at the entity level. This is known as “pass-through taxation.”

A single-member LLC (SMLLC) is treated as a “disregarded entity” by the IRS for federal income tax purposes. Its income and expenses are reported directly on the owner’s personal tax return, on Schedule C, Profit or Loss From Business (Form 1040). The net profit or loss from the business activity is then included in the owner’s individual taxable income.

In contrast, a multi-member LLC is treated as a partnership for federal income tax purposes. Such an LLC must file an informational return with the IRS, Form 1065, U.S. Return of Partnership Income. This form details the LLC’s overall financial performance, including its income, deductions, gains, and losses. Each member receives a Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., which reports their proportionate share of the LLC’s profits and losses. Members then report these amounts on their personal tax returns, on Schedule E, Supplemental Income and Loss (Form 1040). This pass-through mechanism ensures that the business income is taxed only once, at the individual income tax rates of the owners.

Electing Different Federal Income Tax Structures

While LLCs have default federal income tax classifications, they also possess the flexibility to elect to be taxed as either an S Corporation or a C Corporation. This choice can significantly alter the tax obligations of the LLC and its owners, offering potential advantages depending on the business’s financial situation and goals.

An LLC can elect to be taxed as an S Corporation by filing IRS Form 2553, Election by a Small Business Corporation, provided it meets certain eligibility criteria, such as having a limited number of shareholders and only U.S. citizens or residents as owners. S Corporations are pass-through entities, meaning profits and losses are passed through to the owners’ personal tax returns. The primary tax advantage of S Corporation status for an LLC owner who actively works for the business is the potential to save on self-employment taxes.

Owners can pay themselves a “reasonable salary” subject to payroll taxes (Social Security and Medicare), and any remaining profits can be distributed as non-wage distributions, which are not subject to self-employment taxes. The IRS scrutinizes what constitutes a “reasonable salary,” expecting it to reflect what would be paid for similar services by similar businesses under similar circumstances. Factors like training, experience, duties, time devoted, and payments to non-shareholder employees are considered when determining this amount.

Alternatively, an LLC can elect to be taxed as a C Corporation by filing IRS Form 8832, Entity Classification Election. This election subjects the LLC to corporate income tax rules, which include “double taxation.” The C Corporation pays tax on its profits at the corporate level, and then shareholders pay tax again on any dividends received from those after-tax profits. The federal corporate income tax rate is a flat 21%.

Dividends received by shareholders are taxed as qualified dividends at rates of 0%, 15%, or 20%, depending on the shareholder’s taxable income. This structure might be considered by LLCs aiming to retain earnings for significant growth, seeking venture capital investment, or benefiting from certain corporate fringe benefits not available to pass-through entities. The election to be taxed as a C Corporation is limited, with restrictions on how frequently a business can change its tax classification once an election has been made, preventing another change for 60 months.

Self-Employment Tax Responsibilities

LLC owners, particularly those operating under the default classifications of a disregarded entity (sole proprietorship) or a partnership, face specific responsibilities regarding self-employment taxes. These taxes fund Social Security and Medicare, and they apply to the net earnings from the business. Unlike W-2 employees whose employers withhold these taxes, self-employed individuals are responsible for paying both the employer and employee portions.

The self-employment tax rate is 15.3% on net earnings from self-employment. This rate comprises 12.4% for Social Security, applied to net earnings up to an annual wage base, and 2.9% for Medicare, which applies to all net earnings without a wage base limit. For 2024, the Social Security wage base limit is $168,600, meaning earnings above this amount are not subject to the 12.4% Social Security portion of the tax. The 2.9% Medicare portion continues to apply to all net earnings.

A significant aspect of self-employment tax is the ability to deduct one-half of the self-employment taxes paid on the owner’s personal income tax return. This deduction is taken as an adjustment to income on Form 1040, effectively reducing the owner’s adjusted gross income and overall income tax liability. LLC owners are required to pay estimated taxes quarterly to cover both their income tax and self-employment tax obligations. These payments are due on April 15, June 15, September 15, and January 15 of the following year.

The self-employment tax landscape changes for LLCs that elect S Corporation status. S Corporation owners can pay themselves a reasonable salary reported on a Form W-2, which is subject to payroll taxes (the employee and employer shares of Social Security and Medicare). Any distributions taken beyond this reasonable salary are not subject to self-employment taxes, providing a potential tax planning advantage for profitable businesses. This distinction between salary and distributions is a primary reason many LLCs choose S Corporation taxation, as it can reduce the overall self-employment tax burden on the owners.

State and Local Tax Liabilities

Beyond federal income and self-employment taxes, LLCs are subject to various state and local tax obligations that can differ significantly based on the jurisdiction where the business operates. These taxes contribute to the overall financial burden and compliance requirements for an LLC. Understanding these diverse state and local impositions is important for comprehensive tax planning.

Many states impose their own income taxes on businesses. Some states follow the federal pass-through taxation model, where profits and losses are passed through to the owners who report them on their individual state income tax returns. Other states may impose entity-level taxes on LLCs, such as annual registration fees, business privilege taxes, or gross receipts taxes. For instance, some states require an annual fee for the privilege of existing as an LLC, which can range from under $100 to several hundred dollars, regardless of the LLC’s income. Some jurisdictions, like Delaware, assess annual franchise taxes on LLCs, while others, like Texas, levy a franchise tax that applies to many businesses, including some LLCs.

If an LLC sells tangible goods or certain services, it has an obligation to collect and remit sales tax to the state and, in some cases, local tax authorities. The specific rules regarding what is taxable and the applicable rates vary widely by state and locality. If an LLC hires employees, it becomes responsible for state-level payroll taxes, including state unemployment insurance (SUI) taxes, which fund unemployment benefits for eligible workers. These taxes are a percentage of employee wages up to a certain limit, with rates varying based on the state and the employer’s experience rating.

LLCs that own real estate or certain business personal property may also be subject to property taxes levied by local governments, such as counties or municipalities. These taxes are based on the assessed value of the property. Many cities and counties require businesses to obtain specific business licenses or permits, often accompanied by annual fees, and may impose other local privilege taxes or occupational taxes depending on the industry and location. The exact combination and rates of these state and local taxes necessitate research into the specific requirements of the jurisdictions where the LLC conducts business.