For businesses forming a legal entity, corporations and limited liability companies (LLCs) offer company owners certain protections from liability. One of the main differences between the two types of business entities is how they are taxed.
Pass-through taxation for LLCs
An LLC is a form of legal business partnership that consists of members, or people who hold some ownership equity in the LLC. These members can be founders or executives of the company, or employees who are granted equity as part of their compensation package.
LLCs are eligible to be taxed as “pass-through” entities, meaning that profits and losses are not recognized by the LLC itself—instead, each member’s share of the LLC’s income, losses, deductions, and credits for the tax year are calculated and recognized annually by the LLC’s members. LLC members are responsible for reporting that information on their individual federal income tax returns.
LLCs can be configured in various ways, based on the size of the company and its structure. For example, single-member LLCs, which are similar to sole proprietorships, can be a good option for a small operation with few or no employees. For tax purposes, single-member LLCs that do not elect to be taxed as a corporation are considered “disregarded entities” by the IRS, and the owner pays self-employment taxes and reports all business activity on their personal federal income tax return.
→ Learn more about LLC tax deadlines for 2023
Does an LLC have double taxation?
LLCs avoid double taxation because they are a pass-through entity—there is no tax on profits at the LLC level, only at the individual member level.
Corporations, by contrast, file and pay taxes on the corporation’s income directly to the IRS, and shareholders of the corporation also may owe individual income taxes on any distributions from the corporation. This is sometimes referred to as “double taxation,” because corporations are taxed at both the corporation level and at the individual shareholder level.
How do LLC taxes work?
Since LLC members are responsible for reporting their share of the LLC’s tax liabilities, they must know what those liabilities are. So how do they find out this information? Enter the K-1.
K-1 tax form for LLCs
On an annual basis, LLCs prepare and distribute to each member what’s known as a Schedule K-1 form. The Schedule K-1 is a tax document that breaks down each partner’s share of the partnership’s income, losses, deductions, and credits for the tax year.
LLCs and other partnerships also include all K-1s in the partnership’s tax return, called a Form 1065.
LLCs may also choose to be taxed like C-corporations. In that case, the LLC would pay taxes, rather than passing it on to partners.
How different types of LLC equity are taxed
LLCs may grant various types of equity to their members, such as membership interests, profits interest units, phantom equity and unit appreciation rights, and the type of equity granted may affect how the recipient is taxed. This is especially relevant once those equity shares are cashed out, for example if the company is acquired.
