If you operate your business using a limited liability company (LLC), then you have more flexibility in choosing how the IRS taxes your business earnings. Your choice will directly influence the tax filing rules you are subject to. There is no set of tax rules that specifically apply to LLCs; the IRS allows the LLC to use partnership, corporate or sole proprietor tax rules.
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IRS default designations
Immediately after you create the LLC, the IRS automatically treats your business as a partnership, but only for income tax purposes. However, if you are the sole owner of the LLC, then you must pay tax on business profits as if you were a sole proprietor. Both designations have different tax filing rules. If you prefer the tax filing rules of a corporation, then you have the option to elect corporate tax treatment by filing IRS Form 8832. Once you make this election, you cannot change the LLC designation again for five years.
Partnership filing requirements
Limited liability companies that are subject to the partnership tax rules are not responsible for actually paying the tax on business earnings, but are responsible for preparing annual partnership tax returns on IRS Form 1065. This return is for informational purposes only; all income, deductions and credits are reported by each individual owner.
The LLC reports each owner's share of these amounts on a Schedule K-1 at the end of the year. For example, if you and a friend create an LLC to run a business that earns $100,000 and has $60,000 of deductible business expenses, then each of you will receive a Schedule K-1 with $50,000 of earnings and $30,000 of deductions. Both of you must then report these figures on your personal income tax returns. Essentially, the business will increase your personal taxable income by $20,000.
Corporate filing requirements
If you decide to make a corporate tax election for the LLC, the IRS will treat your business as a separate taxpayer in the same way you are a separate taxpayer from your friend. As a result, the business is solely responsible for reporting all income and deductions on Form 1120 each year and paying the appropriate income tax by the deadline.
If the LLC fails to pay the tax or file a return, you and the other owners are not personally liable. However, a drawback to corporate treatment is that business earnings are taxed twice. The first level of tax occurs when the LLC files a corporate tax return, and the second is imposed on the owners when they receive a dividend. Each owner must report the dividend as taxable income on their personal Form 1040s and pay tax on it.
Sole proprietor filing requirements
In a sole proprietorship, the IRS disregards the LLC entity as being separate and distinct from the owner. Essentially, this means that you are personally responsible for all tax payments and filings. When you prepare your personal income tax return, you must now also complete a Schedule C attachment. The Schedule C only reports the income and deductions that relate to your business activities. If you calculate a profit on Schedule C, then the amount is included with the other income your report on Form 1040.