Posted by Abundant Wealth Planning LLC

How Does an LLC (Limited Liability Company) Pay Income Tax?

How Does an LLC (Limited Liability Company) Pay Income Tax?

An LLC (limited liability company) is a form of business organization recognized by all states. Forming an LLC provides limited liability protection to owners (called "members") who pay taxes based on their personal tax rates.

How an LLC pays income tax depends on whether the LLC has one or more members and whether the limited liability company elects to be treated as another form of business for tax purposes. To start an LLC, you must register in the state where you wish to do business by completing the Articles of Organization (or a similar application). 

The internal revenue department does not recognize LLCs for tax purposes. So how does a limited liability company pay income tax?

How a sole member LLC pays income tax

The IRS considers a single LLC member to be a disregarded entity. In other words, LLC is not separate from the owner of the business for income tax purposes. Being a disregarded entity implies that the limited liability company is taxed in the same way as a sole proprietorship. The income and expense information of the LLC and its net income are calculated by preparing Schedule C. The net income from Schedule C is reported on the owner's income tax return (Form 1040 or 1040- SR).

How a multi-member LLC pays income tax

A multi-member LLC generally pays income tax as a partnership. The business (partnership) itself does not pay taxes directly to the IRS; individual partners pay taxes based on their participation in the partnership.

Filing your income as a member of an LLC involves several steps:

  • Step 1: The partnership sends an information return to the IRS on Form 1065.

  • Step 2: You receive a Schedule K-1 prepared for each partner, showing their share of the profits or losses of the partnership.

  • Step 3: You must transfer the information from Schedule K-1 to Schedule E - Additional Income. The Schedule K-1 that you receive from LLC divides your income into different types, and each type of income goes to a specific position in Schedule E.

  • Step 4: Enter the income from your Schedule E in the correct place on Form 1040 or 1040-SR.

The IRS considers rental income, including Airbnb income, to be passive income. Normal business losses are not limited, but passive income losses are limited if you are not in business, so you must report this income separately.

Income tax for LLC classified as corporations or S Corps.

Some LLCs choose to pay taxes as a corporation or S corporation. Usually, businesses make this choice (called an "election") because it results in lower taxes for high-income earners. Elections are submitted via IRS Form 8832 - Entity Classification Election.

This tax option does not change the way your LLC operates; it merely changes the way you pay your taxes. Your limited liability company continues to operate as an LLC according to the Company's Operating Agreement.

LLC and real estate rental income

Suppose part or all of your income as a member of an LLC comes from rental income. In that case, LLCs should use Schedule E to report additional income for Form 1040 instead of Schedule C. Additional income is income from the rental of real estate or royalties owned by the LLC, including assets. 

LLC owners and self-employment tax

LLC owners typically earn income from business operations. This income is considered self-employment income and is subject to self-employment tax (social security and health insurance). You must complete Schedule SE to calculate the amount you owe based on your business's net income. The total is added to other income on your income tax return.

The income in Schedule E from rental real estate (Box 2 in Schedule E) is generally not subject to self-taxation. It is considered a passive asset (inactive, like a business), and the income of LLC members from this passive asset may be subject to the passive loss limitation rules.

How LLC Pays State Income Tax

Each state has different ways of classifying LLCs for income tax purposes. Once you have established the tax status of your LLC, you can go to the state revenue department to find out how state taxes can be imposed.

You will need to consider two factors:

  • How does the tax classification of LLCs (sole proprietorship, partnership, S corporation, or corporation) affect state income tax?

  • What is the tax based on? Most states use federal passive income tax as the basis, but states change this basis for their state tax & some states call it income tax-deductible. Other states may charge gross income tax from LLCs instead of income tax.



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