Key Takeaways
- If your LLC has more than one member, the IRS assumes that it’s a partnership. As such, the LLC should file Form 1065: Partnership Return of Income for tax purposes.
- An LLC that is taxed as a partnership pays no federal income tax itself. Instead, it passes its taxable profits and deductible losses through to its members.
- An LLC taxed as a partnership files a Schedule K-1 for each member, reporting the member’s share of LLC income, deductions, and other items. The member reports these amounts on their personal tax return.
- If you choose to have your LLC taxed as a corporation, use Form 1120: Corporation Income Tax Return (or Form 1120S if you choose to be taxed as an S-corporation) at tax time.
Advantages of self-employment
Self-employed business owners who want to reduce their personal liability for business-related debts and legal problems, but don't want the more complex structure of a corporation, have an alternative: the Limited Liability Company or LLC. This type of business structure has been around for over 40 years, and is now permitted in all 50 states.
Reasons for choosing an LLC
As an owner (or "member") of a Limited Liability Company, typically you're only partially on the hook for unpaid debts or court judgments against your business: Your losses are generally limited to your investment in the company.
The same is true if you form a corporation, but when you opt for that business structure, you can lose a lot of the management flexibility you enjoyed as a sole proprietor (or you and your partners enjoyed in your partnership).
With an LLC, however, you can often hold on to that flexibility: You can have an unlimited number of members, or just one. A member can be an individual, a partnership, a corporation, or even another LLC. Members can run the LLC themselves or hire an outside manager.
You can even choose how you want the business to be taxed: either as a partnership or a corporation (or, if you have a single-owner LLC, as a sole proprietorship). And LLCs don't issue stock, so profits are divvied up any way the members choose, with no need for shareholders' meetings.
Even with all these advantages, there may be situations where you'll opt to incorporate instead. For example, you may want to be able to issue stock, so you can reward key employees by giving them stock options. Also, in some states certain types of businesses, including banks and insurance companies, can't form LLCs.
How to form an LLC
Like corporations, LLCs are governed by state law. You'll need to draft articles of organization in the state where your business is headquartered, file them with the appropriate state office (usually the secretary of state or department of commerce), and typically pay a filing fee.
Most states make the process easy. They usually have a preprinted form where you just fill in the blanks to provide your company's information, or they have a sample form to follow.
For LLCs with more than one member, you'll also need to draw up an operating agreement. Items in this document typically include: the rights and responsibilities of the LLC members; what percentage of the business each member owns; how the business will be managed; how members will make decisions on major issues; what the procedures are for adding new members; and what tax treatment the LLC chooses.
Once you've established an LLC, you may have to pay annual registration fees to the state.
TurboTax Tip:
LLC members who don't take an active role in the business typically don't pay self-employment tax on profits the company passes through to them, only if they receive compensation for any services they provide to the LLC.
Tax treatment of an LLC
The IRS assumes that LLCs with more than one member are partnerships for tax purposes. That means the LLC itself pays no tax, but taxable profits and deductible losses are passed through to the members, who are treated as partners under the tax rules.
So at tax time, to keep the IRS happy, an LLC that chooses to be taxed as a partnership files Form 1065: Partnership Return of Income. The annual Form 1065 must also include a Schedule K-1 for each member. Schedule K-1 reports the member’s share of LLC income, deductions, and other items. These amounts are then included on the member’s personal tax return.
If you choose to have your LLC file taxes as a corporation, you must tell the IRS by filing Form 8832: Entity Classification Election. At tax time you'll use Form 1120: Corporation Income Tax Return, or 1120S if you choose to be taxed as an S-corporation.
If you have a single-member LLC, you'll typically file as a sole proprietorship using Schedule C (unless you choose to treat the LLC as a corporation).
A rather sticky issue for LLC members is whether they owe self-employment tax on their share of the company's earnings. In general, members who are actively engaged in the business must pay this tax.
There is a special rule for LLC members who are the equivalent of Limited Partners and don't take an active role in the business: They typically don't pay self-employment tax on profits the company passes through to them, only on compensation they receive for any services they provide to the LLC.
Here's the rub: The law isn't clear on how inactive an LLC member has to be to qualify for this special rule. The IRS tried to clear things up a few years ago by proposing rules that would require self-employment tax to be paid on profits distributed to any member who is personally liable for the LLC's debts, participates in the business for more than 500 hours annually, or has authority to sign contracts on behalf of the company.
Recent case law has provided some direction as to who is and isn't subject to self-employment tax in an LLC. While it is still not perfectly clear, the IRS's position is typically that any member that has the authority similar to that of a general partner is subject to elf-employment tax on their portion of the business' earnings.
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