How Does a Limited Liability Company Pay Income Tax?

LLC taxes
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A limited liability company (LLC) is a form of business organization recognized by all states. Forming an LLC provides limited liability protection for owners (called "members"), who are taxed at their personal tax rates. 

How a limited liability company pays income tax depends on whether the LLC has one member or more than one member, and whether the LLC elects to be treated as a different business form for tax purposes. 

To start an LLC, you must register with the state where you want to do business, by filing Articles of Organization (or similar application) with the state.

A limited liability company is not recognized by the Internal Revenue Service for tax purposes. So how does an LLC pay income tax? The IRS says that an LLC may be taxed as a partnership or a corporation, or be disregarded as an entity separate from its owner (for a single-member LLC).

How a Single-member LLC Pays Income Taxes

The IRS considers a single-member LLC as a disregarded entity. In other words, the LLC is not separate from the owner for income tax purposes. Being a disregarded entity means that the LLC is taxed in the same way as a sole proprietorship. That is, the information about the LLC's income and expenses, and its net income is calculated by preparing a Schedule C. The net income from the Schedule C is brought over to the owner's personal tax return (Form 1040 or 1040-SR).

How a Multiple-member LLC Pays Income Taxes

An LLC that has more than one member typically pays income tax as a partnership. The partnership itself does not pay taxes directly to the IRS; the individual partners pay tax based on their share of ownership in the partnership.

Reporting your income as an LLC member has several steps:

Step 1: The partnership files an information return with the IRS on Form 1065.

Step 2: A Schedule K-1 is prepared for each partner, showing their share of the profit or loss of the partnership.

Step 3: Schedule K-1 information is transferred to Schedule E - Supplemental income. This is where it gets more detailed, and complicated.

The Schedule K-1 you receive from your LLC breaks down your income into different types, and each type of income goes in a specific place on Schedule E.

For example, ordinary business income from the operations of your LLC on Line 1 of Schedule K-1 is included on Schedule E Part II, Income or Loss from Partnerships and S Corporations. Income from rental real estate on Line 2 of the Schedule K-1 is included on Schedule E Part I Income or Loss From Rental Real Estate and Royalties.

Step 4: Information from Schedule E is included on your Form 1040 or 1040-SR.

The IRS considers income from rental real estate, including Airbnb-type income, as passive income. Losses from normal business activity aren't limited, but losses from passive income are limited, so this income must be reported separately.

Income Tax for LLC's classified as Corporations or S Corporations

An LLC may elect to be classified as a corporation or S corporation for tax purposes. Usually, this election is made because results in lower taxes for high-income individuals. The election is submitted through IRS Form 8832 - Entity Classification Election.

The LLC then pays income tax based on this new tax status, including state income tax. The LLC continues to operate as an LLC, following the company's operating agreement. 

LLCs and Rental Real Estate Income

If all or part of your income as an LLC member LLCs must use Schedule E to report supplemental income for Form 1040 instead of Schedule C. Supplemental income is income from rental real estate or royalties owned by the LLC, including Airbnb-type activities.

LLC Owners and Self-Employment Tax

LLC owners commonly get income from business operations. This income is considered self-employment income and it's subject to self-employment tax (Social Security and Medicare). You must complete Schedule SE to calculate how much you owe, based on your business net income. The total is added to your other income on your personal tax return.

Schedule E income from rental real estate income (Box 2 of Schedule E) generally isn't subject to self-employment tax. It's considered passive activity (not active, as a business) and LLC member income from this passive activity may be subject to passive loss limitation rules.

How LLC's Pay State Income Tax

Each state has a different way of classifying LLC's for state income tax purposes. After you have figured out your LLCs tax status, you can go to your state's department of revenue to find out how your state might be taxed.

You will need to look at two factors:

  • What is the tax based on? Most states use the federal income tax liability as a basis, but states modify that basis for their state tax.
  • How does the LLCs tax classification (sole proprietor, partnership, S corporation, or corporation) affect the state income tax?

Some states call their income tax a franchise tax. Other states may impose taxes on LLCs as a gross receipts tax rather than an income tax.

Article Sources

  1. IRS. "Limited Liability Company (LLC)." Accessed July 2, 2020.

  2. IRS. "Publication 3402 Taxation of Limited Liability Companies." Page 2. Accessed July 2, 2020.

  3. IRS. "Partner's Instructions for Schedule K-1 (Form 1065)." Pages 7-8. Accessed July 3, 2020.

  4. IRS. "LLC Filing as a Corporation or Partnership." Accessed July 3, 2020.

  5. IRS. "Instructions for Schedule E Supplemental Income and Loss." Page 1. Accessed July 2, 2020.

  6. IRS. "Instructions for Schedule E Supplemental Income and Loss." Page E-2. Accessed July 2, 2020.