How taxes work for LLCs

When forming a legal entity for your startup or small business, there are a few options: Should you incorporate your business as a corporation or form a limited liability company (LLC)? 

One of the main differences between these two popular business structures is how they are taxed. LLCs can offer protection from personal liability and additional options for tax structuring compared to C-corps.

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 have several choices when it comes to tax treatment.  For example, only single-member LLCs can be taxed as sole proprietorships, while multi-member LLCs with multiple members are by default taxed as partnerships and can elect to be classified as a corporation for tax purposes.

When an LLC opts to be taxed as a sole proprietor or partnership, it “passes” tax liability from the entity itself up to the individual LLC members.

Single-member LLC taxes

For tax purposes, single-member LLCs are typically treated like Schedule C sole proprietorships. Single-member LLCs that do not elect to be taxed as a corporation are considered “disregarded entities” by the Internal Revenue Service (IRS). The owner pays self-employment taxes and reports all business activity on their personal federal income tax return. 

→ Learn more about single-member LLCs and how they are taxed

Multi-member LLC taxes

As a default, multi-member 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 personal income tax returns. 

LLCs and FICA 

Members of LLCs taxed as sole proprietorships or pass through entities are responsible for paying self employment tax, since FICA taxes (like Social Security and Medicare taxes, were not withheld by the company). 

LLCs taxed as corporations

Alternatively, LLCs can elect to be taxed as a corporation. These selections can be made through IRS form 8832. 

Does an LLC have double taxation?

LLCs taxed as pass-through entities avoid double taxation because there is no tax on LLC profits at the entity 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.

→ Learn more about small business tax planning

How do LLC taxes work?

When taxed as a partnership, individual LLC members are responsible for reporting their share of the LLC’s tax liabilities. Each member receives a Schedule K-1 tax form from the LLC, letting them know their share of the entity's total taxable income or loss..  

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.

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 (UAR), 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.

Download our guide to help you determine the best LLC equity type for your company

Get a step-by-step guide to choosing the right equity plan for your company, so you can attract talent, retain employees and ensure they are invested in the company’s success.