LLC’s Pass Through Income, Deductions to Members
The limited liability company (LLC) is an entity created and governed by state law that has characteristics of both a corporation and a partnership. Under state laws, LLC owners generally have the protection from liability that used to be available only to corporate shareholders. Every state has enacted legislation providing for limited liability companies, although there are slight variations from state to state.
Federal tax law determines the taxation of an LLC by either:
- a default classification based upon the number of members that the LLC has or
- an election by the LLC to be taxed differently than the default treatment.
Most — but not all — states will honor the federal classification and tax the LLC accordingly. However, this is not true in all cases. You’ll need to check your state tax laws to learn the rules for your state.
Number of Members Determines Default Classification
A single member LLC is disregarded for federal tax purposes and is treated as a sole proprietorship whose owner must file a Schedule C with their Form 1040. If there is more than one member, then, by default, the LLC is treated as a partnership. This means that the LLC must file a Form 1065, U.S. Partnership Return of Income and send each member a Schedule K-1. The members report the amounts shown on their Forms K-1 on their own Forms 1040.
Electing Out of Default Treatment. If you do not want your LLC taxed under the default classification, then you can file Form 8832, Entity Classification Election, and elect to be taxed as a corporation. This form needs to be filed only if you don’t want the default classification to apply for federal tax purposes.
How Do LLCs Compare to S Corporations?
While S corporations also provide limited liability for their owners and favorable pass-through tax treatment, LLCs do provide some additional advantages to growing businesses. Like a partnership, an LLC has the ability to make disproportionate distributions to its owners (for example, a LLC member may have a 50 percent ownership interest in LLC assets but be entitled to 60 percent of the income, if the operating agreement so provides).
In contrast, S corporations must generally make all distributions pro-rata in accordance with the number of shares held by each owner. Also, an LLC can have an unlimited number of investors, whereas an S corporation is limited to 100 shareholders.
However, there are also a number of potential downsides to operating as an LLC that is taxed as a partnership. Recent law changes require the prudent tax planners (and business people) revisit the conventional wisdom that the default LLC classification is the best tax choice. An S corporation shareholder can receive both salary and dividend income from the business.
This provides for three significant advantages.
Dividend income is not subject to the self-employment tax.
- Dividend income is not included in determining your earnings for purposes of the 0.9 percent surtax on earning income over $200,000 per year ($250,000 for a married couple).
- Dividend income from your active trade or business is not considered net investment income that may be subject to the 3.8 percent net investment income tax.
Other factors to consider. There are a number of nontax factors that may influence your decision as to whether a LLC is the right form of business for you. We recommend that you seek legal advice in setting up a LLC and writing up the operating agreement.
Limited liability company (LLC). A separate legal entity created by a state filing. Under state laws, LLC owners are given the liability protection that was previously afforded only to owners of a corporation (shareholders). Now, LLCs are treated like partnerships for federal tax purposes (unless they elect to be treated like a corporation, which most don’t). LLCs have “pass-through” taxation, which means that no tax on the LLC’s income is paid at the business level. Income/loss is instead reported on the personal tax returns of the owners, and any tax due is paid at the individual level. Keep in mind, even though LLCs are treated as partnerships for federal tax purposes, the same is not always true for state tax purposes.