Limited liability companies (LLC) became popular in the 1990s, though Wyoming enacted the first limited liability company act in 1977.
A limited liability company is a noncorporate business form which provides its members with limited liability and also allows the members to participate actively in the entity’s management without becoming personally liable for the entity’s obligations. A limited liability company is a state entity and not an Internal Revenue Service entity.
However, it is important to understand how the IRS looks at an LLC. A limited liability company, for tax purposes, is based on the number of members and whether a special designation is made to the IRS.
The IRS has three types of designations for businesses: sole proprietor (one owner), partnership (multiple owners) and corporations. The IRS recognizes a single-member LLC as a sole proprietor and a multiple-member LLC as a partnership by default. Unless the business informs the IRS that it would like a different designation, the default designation is recognized by the IRS for tax purposes.
A single-member LLC is taxed the same as a sole proprietor. This means that the net income of the company is first taxed at the individual’s tax rate and then taxed again at 13.3 percent (2012). This 13.3 percent constitutes Social Security and Medicare taxes, or what is referred to as payroll taxes.
A sole proprietor must pay payroll taxes on all net income. If you are an employee of a company, you have 5.65 percent in payroll taxes withheld from each paycheck. The employer pays the other 7.65 percent portion of the payroll taxes. However, as a sole proprietor, you are responsible for the entire 13.3 percent payroll taxes on your net income.
A multiple-member LLC is taxed as a partnership. A partnership allows for the net income to flow through to the individual member’s tax return, based on the member’s ownership in the company. For example, if there are two members and each have a 50 percent holding in the company, each member will receive a K-1 that designates 50 percent of the net income from the company that is then placed on the 1040 tax return. This amount is not necessarily exempt from payroll taxes, as it depends on the partner’s designation within the company and if a guaranteed payment, sometimes referred to as a draw, is taken from the company.
Both a sole proprietor (single member) LLC and a partnership (multiple members) LLC have the same tax due date as an individual, usually April 15. If the LLC informs the IRS that it would like to be taxed as a corporation or S-corporation, the tax due date is March 15.
Knowing the tax consequences when forming a limited liability company can ease the tax burden at the end of the year. It is important to pay quarterly estimated taxes if you are a single-member LLC or receive guaranteed payments from a partnership to help offset the additional 13.3 percent of tax on the net income from your company.
Just forming a limited liability company with the state does not mean the company is protected from additional taxes. Ask yourself: Is my LLC a single member (sole proprietor) or a multiple member (partnership)? Both of these designations can lead to additional taxes. If another type of entity is preferred, you must submit the necessary forms to the IRS.
For more information, visit www.irs.gov and type limited liability company in the search engine.
Tracy Bunner is an enrolled agent and tax preparer with an office in Harrisville. She can be reached at 801-686-1995 or at email@example.com.