So you have a business in mind, or are probably running a business in the form of a sole-propreitorship.
Now, you want to incorporate it.
Well, that’s a smart choice. Incorporating a business lets you avoid all the legal liabilities that may arise! It becomes the liability of the business structure based upon the organization that you have chosen.
There are several business legal structures in the US and the choice of going with one than the other should be based upon a number of factors, chief among them being, the type of business you operate.
Second in that list of important factors to consider, is the matter of taxation. As a business owner, it is important that you pay careful attention to your business’ finances and ensure the cash outflows are kept to a minimum. This also means you need to ensure your business pays the least tax legally possible.
For that reason, two of the business organizations most favoured by startups are Limited Liability Companies and Limited Liability Partnerships.
In this post, you will learn all about the taxation structures in LLC and LLP as well as which is better for your business.
- Related Information: Need any further help or have any questions regarding your business? Book a free consultation with us.
What are LLCs and LLPs?
A Limited Liability Company (LLC) is a hybrid entity that combines the characteristics of a corporation with those of a sole proprietorship or partnership. It has limited liability, similar to a corporation, and when it comes to taxation, the entity itself is not taxed; rather, the members (owners are referred to as “members”) are taxed.
The IRS defines it as a “pass-through entity,” which means that all profits or losses are passed through to the members’ income and then taxed. Its membership is open to all and there is no limit to the number of people who can join.
If there is only one member, it is taxed as a sole proprietorship and treated as a “disregarded entity,” that is, it is not regarded separate from its owner; if there are two or more members, it is taxed as a partnership. It does, however, have the option of converting into a corporation, and the taxation is then based on how corporations are taxed.
Limited Liability Partnership (LLP) is a legal business structure that is formed just like the general partnership but the liability of the members is limited.
It contains both limited or general partners or either one. Unlike a general partnership, the LLP needs to be registered with the respective state. An LLP is treated as a separate legal entity, however, when it comes to taxation it is taxed in the same way as partnerships are.
- Related Read: How to Form an LLC in the US (in 9 Steps!)
How LLCs are Taxed?
- Income Tax– It will depend on whether an LLC has a single member or multiple members.
- Single-member LLC– it is treated as a sole proprietorship by IRS, which means that LLC does not have to file taxes as an entity, instead, the owner does. It means that all the profits and losses of the LLC have to be shown on Schedule C and submit it with your 1040 tax return.
- Multi-member LLC– it is treated as a co-owned LLC. The tax levied here is not on the income earned by the business, as it is in the case of single-member instead individual incomes of the members are taxed. The ratio of the distribution of income among the members will depend upon what is stated and agreed to by the members in the LLC Operating Agreement. This means that the business’s income will first be divided among the members in the proportions agreed upon, and then the income will be taxed through the respective owner as its own income. The LLC will have to file form 1065 with the IRS, which ensures that the income is correctly reported by the LLC. Then each member of LLC will be provided with Schedule K-1 which lists down the proportion of profits and losses each member is entitled to then and then in turn each member will file its individual income with Form 1040, with Schedule E attached.
Here’s a simple way in which you can understand how you are taxed in a Limited Liability Company.
Step 1 – An LLC is formed formed —–> Step 2 – Determination of percentage of income a member will receive out of total business income is fixed —-> Step 3 – Each member files income as an individual —-> Step 4 – Individual income is then taxed whether actually received or not.
- Payroll Taxes– LLCs that have employees need to collect and pay payroll taxes. It includes unemployment taxes, social security taxes, and Medicare taxes. In social security taxes, and Medicare taxes (collectively called FICA taxes under the Federal Insurance Contributions Act) employers and employees have to pay in proportion to their share. Forms 940 and 941 of IRS are filed. Along with federal payroll taxes, states and local governments often charge additional payroll taxes. While paying employees share of payroll tax you have to withhold the amount from his income.
- Sales Tax– if the LLC sells goods and services that are taxable then it needs to pay sales tax. It will depend on which state or locality or region the LLC is conducting business. It also depends on the mode of taxation followed by the state i.e. whether it is a destination-based tax or origin-based tax.
- Self-employment Tax– As the owners of the LLC the members draw out their share from the business instead of receiving a wage. They are liable to pay income tax on the business amount irrespective of whether they draw out the profit or not (in the case of partnership in proportion to as agreed in LLC operating Agreement).
As the owners don’t receive a wage they are liable to self-employment taxes. The self-employment tax is 15.3% on the income earned in a particular year by the member. The break-up is 12.4% for social security and 2.9% for Medicare.
The self-employment tax rate for the members is 15.3% of net income up to an annual threshold and then 2.9% for income above the threshold amount.
- State Taxes– Most states tax LLC in the way IRS does. However in some states-
- The LLC need to pay tax on the income earned in addition to the income tax paid by the member, eg- California
- Some states impose an additional fee on the LLC that is however not related to its income. It is charged annually and may be called a franchise tax or annual registration tax.
How LLPs are taxed?
- Income Tax– The tax levied here is not on the income of the LLP, instead, it is passed through the income of the individual partners. The ratio of the distribution of income among the members will depend upon what is stated and agreed to by the members in the Partnership Agreement. This means that the business’s income will first be divided among the members in the proportions agreed upon, and then the income will be taxed through the respective owner as its own income. The LLP will have to file form 1065 with the IRS, which ensures that the income is correctly reported by the LLC. Then each member of LLC will be provided with Schedule K.
- Self-employment Tax– As general partners of LLP the members draw out their share from the business instead of receiving a wage. They are liable to pay income tax on the business amount irrespective of whether they draw out the profit or not in proportion to as agreed in the Partnership Agreement. As the owners don’t receive a wage they are liable to self-employment taxes.
However, in the case of limited partners the guaranteed income which is also called as ‘Partners salary’ is taxed for self-employment tax purposes.
This means that only that income which the limited partner is guaranteed to receive will be subject to self-employment tax and not the whole income of the partnership.
- Excise Tax– it is levied on particular goods, products, activities, or services at purchase. This is passed by the business on to the consumer in the form of increased prices.
- Registration Fee– The LLPs have to annually pay the registration fee, failure to do so will have an impact on the limited liabilities of the partner. Along with this, they must also pay the registration fee to the state which varies from state to state.
- Franchise Tax– Some states impose an additional fee on the LLP that is however not related to its income. It is charged annually and may be called a franchise tax or annual registration tax.
LLC vs LLP Taxation: Which is Better?
The discussion arises only when a person decides to go for an agreement where there are various persons who will be considered as owners of the business. Both LLC and LLP enjoy the benefit of limited liability for their members/partners.
- Essential Read: Learn all the legalities involved when starting a company in the US.
But LLC has the tax flexibility as it has the option of converting into S-Corp which provide the members with tax benefits. With the status of S-Corp, the tax levied is of the would-be partnership with profits and losses passed through members’ income.
However, the difference here is that the member will pay self-employment tax on the money/ wage he receives from the business income and not on the profits and losses of the business.
This significantly brings down the tax burden as in many cases the self-employment tax is double the income tax. Another advantage LLC has over LLP is in regards to its limited liability.
If not turned into S-Corp and the member is a limited partner in the LLC Incorporation Agreement, LLC members can actively participate in the business without jeopardizing their limited liability, unlike limited partners in LLP.
But in the case of LLPs the partners for purposes of Self- employment tax, are treated as general partners or like limited partners, depending upon their participation in the operations of the business.
If they participate actively it is most likely that they might lose their limited partner status and will have to pay a significant amount under self-employment tax.
Also, the LLPs are subjected to a mandatory annual registration fee to keep their limited liability status which is not so in the case of LLC.
Hence from the above-given information, I advise that a multi-member LLC would be a better option than an LLP in terms of taxation.
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