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.
If the LLC chooses partnership taxation, it must then choose between Subsection S (taxed as an S-Corp) and Subsection C (taxed as a C-Corp) of the Internal Revenue Code. If taxed as a S-Corp, the situation is very similar to partnership taxation. The difference is that owners can also be employees and recieve a salary. Any profits from the company received in addition to salary is taxed at normal income rates, but are not subject to employment taxes (FICA – Social Security & Medicare withholding) – while the salary portion is subject to employment taxes. The reasoning is that the distributed profits are “unearned income”, while the salary portion is “earned income”. If taxed as a C-Corp, the LLC is responsible for taxes on profits. Any distributions to owners are taxed as a dividend. Because the dividends are not “earned income”, they are not subject to employment taxes.