How will my LLC be taxed?
LLCs, if the members so choose, are taxed as partnerships. The LLC does not pay taxes. The profits and losses in the partnership pass through to the members pursuant to their ownership interest or pursuant to special allocation. Like the partnership, the LLC does have to file an information return and create K-1s to distribute to partners. The K-1s indicate the portion of profits or losses attributable to each member. The members report their share of profits or losses on schedule E of their personal income tax statements.
Members of the member-managed LLC are required to pay self-employment taxes on LLC profits. This is because the LLC members are assumed to be material participants (similar to employees) in the business of the LLC. In a manager-managed LLC, passive members of the LLC who do not materially participate in LLC operations may be able to avoid paying self-employment taxes on LLC profits. The determination as to whether an individual materially participates in the LLC is based on the hours involved in LLC activity. The rules are complicated, but a basic explanation is that, spending 500 or more hours in a year working on the LLC is material participation.