The Internal Revenue Code (IRC) does not impose a separate body of tax law that is applicable to limited liability companies as it does with other business structures such as corporations and partnerships. Federal regulations provide LLC members some flexibility in choosing the type of income taxation to which business profits are subject.
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The IRS automatically disregards the LLC entity when only one member of the LLC exists, designating it as a sole proprietorship solely for tax purposes. All other LLCs receive a default designation as a partnership. However, the members of any LLC are eligible to elect corporate tax treatment by completing IRS Form 8832. Once the owners make a valid corporate election, the decision is binding on the LLC and its member for at least five years. At any time after the initial five year period, members may elect to revert back to partnership or sole proprietorship taxation.
The tax rules governing partnerships apply pass-through principles that attribute all income, losses and credits of the partnership to individual partners. The LLC must first allocate all tax items to each member in proportion to his interest in the business. At the conclusion of a tax year, the LLC reports all financial activity on the partnership informational tax return on IRS Form 1065. The LLC is also responsible for reporting each member’s allocation of taxable income on separate Schedule K-1s, but is not responsible for tax payments. The members transfer the amounts on the K-1 to their personal income tax returns and pay the appropriate amount of tax on both LLC income and other personal income unrelated to the LLC. Each member is solely responsible for reporting and paying his share of the LLC’s taxable earnings. If one member fails to pay the tax, neither the LLC nor its members are liable.
Sole Proprietorship Taxation
A sole proprietor is subject to similar pass-through principles as the partners of a partnership. The sole member of the LLC need not report a separate business return; rather, the member reports all LLC income and deductions on the Schedule C attachment to a personal tax return. The single member is solely responsible for complying with all tax reporting and payment requirements since the IRS disregards the existence of a legal entity separate from the member.
C Corporation Taxation
If the LLC makes an election for corporate tax treatment, the members are treated in the same manner as a corporate shareholder. The IRS views the LLC as a taxpayer separate from its members. The LLC must report all business income and deductions on the IRS Form 1120 and is solely responsible for paying tax liabilities in full. In the event the LLC is deficient in meeting tax obligations, members have no liability to pay the outstanding tax balance. However, the LLC members are subject to a second level of tax when the LLC makes after-tax profit distributions. Similar to a shareholder dividend, members must report the income on a personal tax return in the year they receive the distribution.