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LLC and Tax

What is a Limited Liability Company?

Limited Liability Company’s (“LLCs”) are a creation of state law. An LLC is somewhat of a hybrid entity in that it can be structured to resemble a corporation for owner liability purposes and a partnership for federal income tax purposes. A LLC offers the limited liability the benefit of a corporation and the single level of taxation of a partnership. The owners, not the entity, are then responsible for the payment of the tax, if any.

How are LLCs Taxed?

An LLC’s income passes through to its members, who report the income on their personal income tax returns. For tax purposes, a single member LLC is treated as a sole proprietorship, and a multi-member LLC is treated as a partnership.

The LLC itself does not ordinarily pay federal income taxes on its own behalf as a separate entity (some states impose taxes on LLCs as a separate entity). However, an LLC is required to file an annual informational tax return with the Internal Revenue Service.

It is possible for an LLC to elect to be taxed in the same manner as a “C” corporation (double taxation), but this is generally not advisable, as this election will last for a minimum of five (5) years and as there may be tax consequences for switching back to pass-through taxation.

How are LLC Members Taxed?

An LLC member is subject to self-employment taxes (the current self-employment tax rate is 15.3%) on his/her share of LLC profits, if any, one of the following conditions apply:

  • He/she works more than 501 hours for the LLC during the LLC’s tax year (members who do not play a role in the management of the LLC or who are not employed by the LLC, but simply receive a share of the profits by virtue of their ownership interest, may be exempt from paying self-employment taxes);
  • The LLC offers professional services in the areas of consulting, health, law, engineering, architecture, accounting, or actuarial science;
  • He/she is allowed to execute contracts for the LLC.

In most cases, members will be required to make quarterly payments of their estimated tax liability to both the state and to the federal government.

In some cases, classification as a self-employed taxpayer is preferable to being treated as an employee. For example, deductions for business expenses of self-employed workers are above-the-line deductions under Internal Revenue Code Section 62(a)(1) and reduce the taxpayer’s adjusted gross income. Most employee business expenses are itemized deductions, and are also “miscellaneous itemized deductions”. Taxpayers can deduct miscellaneous itemized deductions only to the extent that the total amount of those deductions exceeds 2% of adjusted gross income. For most taxpayers, this means that miscellaneous itemized deductions cannot be deducted at all.

One of the major benefits of being considered self-employed arises when a taxpayer has to pay for premiums for health insurance. Self-employed taxpayers can fully deduct the cost of health insurance. Whereas, employees can only deduct the cost of premiums that they pay only to the extent that the premiums exceed 7.5% of their adjusted gross income.

How Will a Member who is also an Employee of an LLC be Treated for Federal Income Tax Purposes?

In general, a member cannot also be an employee of the LLC. Thus, a member that becomes an employee of the LLC will be treated as a member for federal income tax. The LLC should not provide a Form W-2 to the member. Instead, the member should receive a Schedule K-1 from the LLC that reflects his or her distributive share of the LLC's items of income, gain, loss, deduction, or credit for the taxable year and amounts transferred as distributions. Instead of paying FICA taxes on amounts received as wages from the LLC, the member's distributive share of LLC items may be subject to self-employment tax under Internal Revenue Code Section 1401. Certain fringe benefits may be taxable to the member, including group term life insurance under Internal Revenue Code Section 79 and payments received under accident or health plans under Internal Revenue Code Section 105.