Pros and Cons of Taxation as an LLC in Colorado
Pros and Cons of Taxation as an LLC in Colorado
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A Limited liability company (LLC) is a "pass-through" entity. The profits and losses of the company pass through the business to the LLC owners or members who report the information on their personal tax returns.
Single-Owner LLC
For tax purposes, the IRS treats one-member LLCs as a sole proprietorship. This would mean no taxes for the LLC and no filling of income tax returns with the IRS. Being the owner of an LLC, you will be required to submit a report of the profits or losses on Schedule C with the Form 1040 tax return. When you decide to leave some of the profits in the company's bank account at year's end for future expenses, you will still pay the income tax for that particular money.
Multi-Owner LLCs
Two owners of an LLC, will be treated by the IRS as a Partnership. Like the one-member LLC, a co-owned LLC does not pay taxes on business income, but the members will pay taxes based on their share of profits to be reported on their personal income tax returns together with the Schedule E attached. This sharing of profits and losses is called distributive share and should be indicated in the LLC operating agreement.
How an LLC Divides Profits
Profits are distributed to each member depending on his/her percentage interest in the business. If a person owns 60% of the company, he/she will get 60% of the profits and losses. If the company decides to divide up the profits and losses in a way that is not proportionate to the members' percentage interest, it is called a "special allocation."
How to Tax a Member's Distributive Share
The IRS treats LLC members as though they receive their entire distributive share of each year's profits regardless of how much money is actually paid out. The purpose of this IRS rule is for the LLC members to be taxed based on their rightful share of the earnings, even if some of the money is reinvested in the LLC for expansion of the business.
File Form 1065 with the IRS
A co-owned LLC is not required to pay its own income tax but is required by the IRS to file Form 1065. This is an informational return reviewed by the IRS to determine if the members have reported their income correctly. The LLC is also required to provide its members with a Schedule K-1 showing each member's share of profits and losses. The LLC members report this information on their individual Form 1040 with the Scheduled E attached.
Electing Corporate Taxation
An LLC can choose to be treated like a corporation for tax purposes by filing IRS Form 8832. This is helpful if the LLC regularly needs to keep a large amount of profits or "retained earnings" within the company. Corporate taxable income is lower than individual income tax that is usually applied to LLC owners. This can save you and the co-owners money in overall taxes.
Estimating and Paying Taxes
Withholding taxes is not practiced in an LLC because the owners are considered self-employed. With this regard, all LLC members will be responsible for setting aside money intended for taxes based on their share of the profits. They must estimate the amount of money they owe the IRS for the year (and the state if there is a state income tax) and make quarterly payments in April, June, September, and January. Self-Employment Taxes
Since LLC members are considered self-employed, they make Medicare and Social Security payments directly to the IRS on the earnings they derive from the LLC. Owners who are active in the day-to-day operating of the business pay these taxes on their distributive share. The owners who are investors with no operational responsibilities may be exempt from paying these self-employment taxes from their share of the profit.
Expenses and Deductions
What can be considered as deductible expenses that you can "write off" from your business income? Identifying these can significantly lower the profits that you must report to the IRS. Deductible expenses include:
Startup costs
Automobile and travel expenses
Equipment costs
Advertising and promotion costs
State Taxes and Fees
In most states the LLC does not pay a state tax, but LLC members pay individual state taxes on their tax returns. In addition, depending on the state where the LLC is located, there may be an annual LLC fee that is not income related. This is known as a "franchise tax", "annual registration fee", or "renewal fee."