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Limited Liability Company Taxes

Updated for Tax Year 2015


OVERVIEW

Self-employment has its benefits. An LLC can help reduce your liability without reducing your freedom to run your business as you see fit. And we have you covered at tax time, with TurboTax Home & Business for single-member LLCs, and TurboTax Business for multiple-member LLCs.


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 30 years, and is now permitted in all 50 states.

Reasons for choosing an LLC

As an owner (or "member") of a Limited Liability Company, you're only partially on the hook for unpaid debts or court judgments against your business: Your losses are 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 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 hold on to that flexibility: You can have an unlimited number of members, or just one. A member can be an individual, a partnership or even a corporation. 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 company is headquartered, file them with the appropriate state office (usually the secretary of state or department of commerce), and 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 should 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.

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 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, deduction, and tax credit 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 the short form, 1120-A.

If you have a single-member LLC, you'll 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 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.

And even if none of those characteristics applied, the proposed rules would require you to pay the tax if you're a member of an LLC in health, law, accounting, engineering, architecture or consulting. Although the rules haven't been made final, the IRS has said it won’t challenge anyone who follows them on this issue.

Choose TurboTax Home & Business if you have a single-member LLC that is treated as a sole proprietorship. If you own an interest in a multiple-member LLC (or a partnership, S corporation or C corporation), choose TurboTax Business.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.


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