Taxation of Limited Liability Companies (LLCs)
A limited liability company (LLC) is a business entity created by state law, the Michigan Limited Liability Company Act of 1993. After forming an LLC you must take certain steps to keep your business in compliance with this law.
State LLC taxes and fee
Michigan taxes LLC profits the same way as the IRS: the LLC’s owners pay taxes to the state on their personal tax returns. The LLC itself does not pay a state tax, but Michigan does require LLCs to file an annual report, due February 15 each year, with a filing fee of $25.
Federal Taxes
Depending on an LLC’s elections and its number of members, the IRS will treat an LLC either as a corporation, a partnership, or, if a sole proprietor, as part of the owner’s tax return.
Single-Member LLC
An LLC with only one member is not treated as a separate entity from its owner for income tax purposes, but it is treated as a separate entity for employment tax and certain excise tax purposes.
If a single-member LLC does not elect to be treated as a corporation, the LLC is a “disregarded entity.” This means the LLC’s activities should be included on its owner’s federal tax return. If the owner is an individual, the LLC’s activities should be reflected on one of three IRS Forms: 1) Form 1040 Schedule C (Profit or Loss from Business (Sole Proprietorship), 2) Schedule E (Supplemental Income or Loss), or 3) Schedule F (Profit or Loss from Farming).
An individual owner of a single-member LLC that operates a trade or business is subject to a tax on net earnings from self-employment (same as a sole proprietorship).
Multi-member LLC’s
An LLC with at least two members is classified as a partnership for federal income tax purposes, unless it elects to be treated as a corporation, which it can do by filing a Form 8832 with the IRS.
Partnerships
The IRS taxes each partner’s share of partnership income at each partner’s ordinary income tax rate. If the LLC paid no employment taxes on the amounts attributable to each partner, then each partner also has to pay self-employment tax on the amount of partnership income attributed to his or her share of income.
Pass-Through Entity
The IRS treats an LLC a “pass-through entity” for tax purposes, similar to a partnership or sole proprietorship. This is because all of the LLC’s profits and losses “pass through” the business to its owners (members) personally, who must report this information on their personal tax returns.
Income Taxes
The IRS taxes an LLC like a sole proprietorship or a partnership, depending on its number of members.
Single-Owner LLCs
The IRS taxes single-member LLCs as sole proprietorships. This means the LLC does not pay taxes and does not have to file a tax return with the IRS.
Multi-Owner LLCs
The IRS taxes co-owned LLCs as partnerships. Co-owned LLCs do not pay taxes on business income. Instead, the LLC owners each pay taxes on their share of the profits on their personal income tax returns. Each LLC member’s share of profits and losses, called a “distributive share,” is included in the LLC operating agreement.
Taxes Assessed on Each Member’s Entire Distributive Share
The IRS treats each LLC member as though the member receives his or her entire “distributive share” each year. Each member pays taxes on his or her entire distributive share whether or not the LLC actually distributes all (or any) of the money to its members. Even if LLC members need to leave profits in the LLC, each is liable for income tax on his or her share of that money.
File Form 1065 with the IRS
Even though a co-owned LLC does not pay its own income taxes, it must file Form 1065 with the IRS. The IRS reviews this Form to be certain that all LLC members correctly report their income.
The LLC must also provide each LLC member with a Schedule K-1. This shows each member’s share of the LLC’s profits and losses. Each LLC member reports this profit and loss information on his or her own individual Form 1040, Schedule E.
No Employment Taxes on LLC; Estimating and Paying Self-Employed Income Taxes
Each LLC member is considered to be a self-employed business owner rather than an LLC’s employee, so the LLC is not subject to employment tax withholding. Instead, each LLC member must pay self-employment taxes on that member’s distributive share of the profits.
LLC members must estimate the amount of tax they will owe for the year and make quarterly payments to both the IRS and the Michigan Department of Treasury. However, owners who are not active in the LLC (those who merely invest money but don’t provide services or make management decisions for the LLC) may be exempt from paying self-employment taxes on their share of profits.
For additional information about taxation of limited liability companies, please contact us.