If you’ve organized your business as a LLC, then you are probably aware that you can choose for the LLC to have its profits and losses taxed at the federal level in one of several ways (although many states follow the federal structure, be sure to check with your attorney or state revenue agency to ensure what your options are).
By default, depending on whether the LLC is a single-member LLC or has multiple members, a LLC is either disregarded or taxed as a partnership, respectively. If the LLC is disregarded, it does not have to file tax returns — instead, if you actively participated in a trade or business, the business profits and losses are reported on Schedule C of your 1040 and you also pay self-employment taxes (passive activity, such as owning income property, are reported on Schedule E instead, and no self-employment taxes are owed). Multi-member LLCs are taxed as partnerships. The LLC income or loss is reported on a separate partnership tax return; then, each member reports his or her share of the income or loss on Schedule E of their 1040. Again, members pay self-employment taxes if they actively engaged in the business.
Alternatively, all LLCs, whether single-member or multi-member, can elect to be taxed as either a C corporation or a S corporation. To choose C corp taxation, the LLC files Form 8832 with the IRS. The corporation must file a corporate tax return and pay taxes on any profits at the corporate tax rate. If the LLC chooses to distribute any remaining profits to the members, the members then have to pay tax on those distributions at the qualified dividend tax rate. The benefit to C corp taxation is that it allows owners to keep profits within the business without any incurring any personal tax liability for them — unless and until distributions are made, only the business is liable for any tax on profits.
To elect S corp taxation, a LLC again files Form 8832. The LLC still files a corporate tax return; however, the LLC does not owe any tax. Instead, each member’s share of the LLC’s profit and loss is reported on each member’s tax return on Schedule E.
With S corp or partnership taxation, each member is individually and personally liable for the tax on his or her share of the LLC’s profit, whether or not any profit is actually distributed to the members. Therefore, many LLC operating agreements, where the LLC is taxed as a partnership or an S corp, have a clause requiring and authorizing a minimum distribution of LLC profits to the extent to cover each member’s portion of the LLC tax liability.
Of course, business must pay a reasonable wage to all owners who actively participate in the conduct of the business. Wages paid are distinct from any distribution of business profits and losses and are reported as ordinary income.
Although an LLC can make multiple elections over the course of its existence, once it files a Form 8832 to make an election it may not file another Form 8832 for five years. Therefore, an LLC should consult with its tax advisor before making a tax election.