This is a guide for LLC members that are tired of vague “well it depends” answers and are ready to talk turkey! This guide spells exactly what taxes you can expect to pay based on your situation.
LLC members are taxed differently depending on: their participation in the company, the entity’s tax classification, and how that income is categorized for tax purposes.
Each of these options can have dramatic tax consequences and we will talk about each one. We’ll also explore each of the individual taxes typically paid by every kind of member. We’ll also be introducing options you can explore based on your situation.
Legal Disclaimer
This article is intended to help clarify your situation, but it’s not a replacement for discussing the full context of your situation with a qualified tax and legal professional!
How to Choose
Let’s go over what you need to know to navigate this guide: specifically your membership within your LLC and its’ tax classification. We’ll go over some quick tests to help you decide which of the 2 basic kinds of LLC membership you’ll fall into and how your LLC is taxed. Once you feel confident, jump back up to the table above and choose the best category.
Selecting Your Membership Type
In this guide you can choose to be either a “member manager” or a “passive member”. For the vast majority of LLCs you’ll likely be a member manager also known as an active manager. If you’re an investor in your LLC you’ll want to be sure you qualify as a passive member (also called a silent partner or a limited partner within legal documents). Sometimes membership can fall into gray area however here are some common tests if you’re still unsure:
- You are not personally liable for the LLC's debts.
- You cannot make contracts for the LLC.
- You participated in the LLC's business less than 500 hours per year.
- When less than 500 hours, was your participation substantial relative to other members or even employees?
Some of these are subjective and many other tests exist, so if you have any questions or concerns: you should contact a tax attorney! If you claim to be a passive member the IRS may challenge you someday. Therefore be sure you can pass these tests with flying colors, before you claim passive member tax treatment.
Why Membership Matters
For tax purposes it’s usually far better to be a passive member, hence all the strict legal requirements. The IRS has taken aggressive legal action against LLC members avoiding taxes through an incorrectly chosen membership.
Again the vast majority of LLC members are member managers not passive investors. Who qualifies as a passive member, legally speaking, can get complicated so be sure to speak to an Attorney or CPA if you’re unsure.
Selecting A Tax Classification.
An LLC can be taxed as either a: sole proprietorship (single member LLCs), partnership (multi-member LLC), S-Corp, or C-Corp. Determining your tax classification is easier than it sounds because you're either using your default status or one you've expressly chosen. So if you’re not sure it's very likely you're using your default tax classification: sole proprietorship (if you're the only member) or partnership (you're jointly running your business with other members).
For those of you that are still unsure, it’s more likely you’re an S Corp than a C Corp. To be sure, look up your past tax filings. If the IRS accepted your form 2553 then you may be an S Corp. If the IRS approved your form 8832 then you may be a C Corp. Please note failing to maintain an opt-in tax classification properly may have caused you to lose it.
If you’re curious about your LLC’s tax options and how you can use them to grow your business, check out our in-depth guide on LLC tax classifications and how to choose one based on your business goals.
Member Manager of a Single Member LLC
Also known as a freelancer, contractor, and 1099, the single member LLC is taxed as a sole proprietorship. The IRS effectively disregards your LLC and passes through income to your personal taxes. All this income is considered earned self employment income that will pay the following taxes:
| Tax | Cost |
|---|---|
| Self Employment | $$$ |
| FICA/Payroll | - |
| Income Tax | $$$ |
| Capital Gains | - |
Note that if you earn less than $400 from your business you may not owe any self employment tax.
Paying Taxes
You’ll generally want to pay estimated taxes and withholdings on your income quarterly. Important forms for single member LLCs are:
- 1040-ES - Used to report your quarterly estimated tax payments.
- Schedule SE - Reports all your self employment income for the year.
Reducing Taxes
When Self Employment taxes become a major cost for your business, you should consider becoming an S Corp. You can use our free tax calculator to compare your current LLC to an S Corp. Luckily as the only member of your LLC it’s far easier to become an S Corp as well.
We discuss this tax profile more later in Member Manager of a S Corp/LLC.
Member Manager of a Partnership/LLC
Sometimes called a “partner”, member managers of a multi-member LLC are taxed as a partnership by the IRS. That means your profits are passed through to members according to your LLC’s operating agreement. Each member then reports their share as earned self employment income. This income will be subject to the following taxes:
| Tax | Cost |
|---|---|
| Self Employment | $$$ |
| FICA/Payroll | - |
| Income Tax | $$$ |
| Capital Gains | - |
Note that if you earn less than $400 from your share of business income may not owe any self employment tax.
Paying Taxes
You’ll generally want to pay estimated taxes and withholdings on your share of this income quarterly. Important forms for multi-member LLCs are:
- Form 1065 - Report partnership income, losses, etc annually.
- Schedule K-1 - Report each partner’s share of income, losses, etc annually.
- 1040-ES - Used to report your share of quarterly estimated tax payments
- Schedule SE - Reports your share of income as self employment for the year
Reducing Taxes
When Self Employment taxes become a major cost for you and your partners, you should consider forming an S Corp. Please try our free tax calculator to compare a similar kind of LLC to an S Corp. While it compares single member LLCs any savings it finds is still applicable to you and your partners.
We discuss this tax profile for you and your fellow members later in Member Manager of a S Corp/LLC. Also check out our guide on LLC tax classifications to be sure the S Corp’s ownership limits won’t become an issue for reducing your taxes.
Passive Member of a Partnership/LLC
For investors with no material participation in their multi-member LLC (taxed as a partnership) you’ll get taxed on passive income. If you’ve held your shares of the LLC for over a year you’ll be taxed at the lower long term capital gains tax rate, otherwise you’ll pay the higher short term rates.
| Tax | Cost |
|---|---|
| Self Employment | - |
| FICA/Payroll | - |
| Income Tax | - |
| Capital Gains | $$ |
Note for high income earners: you may be subject to an additional net investment income tax of 3.8% beyond your capital gains tax rate.
Paying Taxes
You may owe taxes at the end of their year depending on what tax rate applies to you. Important forms for passive members of LLCs are:
- Form 1065 - Report partnership income, losses, etc annually.
- Schedule K-1 - Report each partner’s share of income, losses, etc annually.
- Schedule D - Reporting capital gains and losses.
- Others may apply depending on your situation.
Member Manager of a S Corp/LLC
As a member manager actively involved in your S Corp/LLC you’ll be taking a salary as a W-2 employee and also non-salary compensation. While you do not technically pay self employment taxes, there’s a similar tax called FICA (also called payroll) imposed on your salary. The good news here is that any non-salaried compensation from your LLC will only pay income taxes resulting in significant tax savings!
| Tax | Cost |
|---|---|
| Self Employment | - |
| FICA/Payroll | $ |
| Income Tax | $$$ |
| Capital Gains | - |
Classifying your LLC as an S Corp can be a great tax strategy for both single member and multi-member LLCs that are eligible for it. While you can’t completely avoid FICA taxes, the ability to compensate yourself beyond a “reasonable salary” can tremendously improve your tax savings. You’ll need to work with a CPA in order to set your own reasonable salary. See if you should consider becoming an S Corp using our free calculator. There’s no sign up required.
Paying Taxes
You’ll generally want to run payroll on all member salaries and include income tax withholding as well. Payroll forms need to be filed quarterly. Important forms for S Corporations are:
- Form 1120-S - Reports income, losses, etc of an S Corp annually.
- Schedule K-1 - Report each member’s share of income, losses, etc annually.
- Payroll forms including: 940, 941, W-2, W-3 etc. 941’s need to be filed quarterly.
Passive Member of a S Corp/LLC
As a passive investor in an S Corp/LLC you do not have to pay Self Employment Taxes, FICA, or income taxes on your compensation. Your passive income will be subject to capital gains based on how long you’ve been a member of the S Corp. If you’ve owned the shares less than a year you’ll owe the short term capital gains tax rates, otherwise you’ll own the lower long term rates.
| Tax | Cost |
|---|---|
| Self Employment | - |
| FICA/Payroll | - |
| Income Tax | - |
| Capital Gains | $$ |
If you’re considering becoming a passive member in an S Corp/LLC be aware of the ownership restrictions. You’ll need to invest as an individual, not as an LLC you own. Other restrictions are also worth researching, so speak with your CPA before investing in an S Corp.
Note for high income earners: you may be subject to an additional net investment income tax of 3.8% beyond your capital gains tax rate.
Paying Taxes
You may owe taxes at the end of their year depending on the tax rate that applies to your S Corp distributions. Important forms for passive members of S Corps are:
- Form 1065 - Report partnership income, losses, etc annually.
- Schedule K-1 - Report each partner’s share of income, losses, etc annually.
- Schedule D - Reporting capital gains and losses.
- Others may apply depending on your situation.
Member Manager of a C Corp/LLC
As a member manager of your C Corp you’ll be taking a salary paying FICA and income taxes. In addition you can receive compensation through dividends as well. While these dividends are subject to double taxation at the corporate level they probably have better tax treatment than a salary. Your correct proportion of salary to dividend compensation needs to be discussed with a CPA.
| Tax | Cost |
|---|---|
| Self Employment | - |
| FICA/Payroll | $$ |
| Income Tax | $$$ |
| Capital Gains | $ |
The capital gains here are applied to the dividend compensation while the other taxes are imposed on the member’s salary. Please note that corporate taxes aren’t listed in the table but will apply to dividends.
Paying Taxes
You’ll generally want to run payroll on all member salaries and include income tax withholding as well. Payroll forms need to be filed quarterly. Important forms for S Corporations are:
- Form 1120 - Reports income, losses, etc of a C Corp annually.
- 1099-DIV - Report dividend payments annually.
- Payroll forms including: 940, 941, W-2, W-3 etc. 941’s need to be filed quarterly.
For those considering the C Corp: it’s advantages have to be carefully understood and weighed against the S Corp. A common reason for selecting a C Corporations is for fundraising purposes, less so for tax savings.
Passive Member of a C Corp/LLC
As a passive investor in a C Corp/LLC you’ll largely only have to pay capital gains taxes on your payments. This is because you’re generally compensated through dividends, not a salary; that allows you to avoid FICA and income taxes. Be sure you meet all qualifications of a passive member by speaking with a CPA or tax attorney.
| Tax | Cost |
|---|---|
| Self Employment | - |
| FICA/Payroll | - |
| Income Tax | - |
| Capital Gains | $$ |
Note for high income earners: you may be subject to an additional net investment income tax of 3.8% beyond your capital gains tax rate. Please also note that corporate taxes aren’t listed in the table but do apply to dividends.
Active Rental Property Owner LLC
These are member(s) of a regular (disregarded) pass through LLC owning rental property in which they do have material participation. This often means you help look for tenants and or manage the property in other ways. This could also mean you are classified by the IRS as a real estate dealer. This will be considered earned income by the IRS.
| Tax | Cost |
|---|---|
| Self Employment | $$$ |
| FICA/Payroll | - |
| Income Tax | $$$ |
| Capital Gains | - |
Paying Taxes
Important forms for you are:
- Schedule E - Report income or losses annually.
- Schedule D - Report capital gains and loses annually.
Non-Active Rental Property Owner LLC
These are members of LLCs owning rental property in which they have no material participation. This often means you do not look for tenants, manage the property, and are not considered a real estate dealer. This is usually considered tax advantaged passive income by the IRS as long as you do not qualify as an active participant.
| Tax | Cost |
|---|---|
| Self Employment | - |
| FICA/Payroll | - |
| Income Tax | - |
| Capital Gains | $$ |
Note for high income earners: you may be subject to an additional net investment income tax of 3.8% beyond your capital gains tax rate.
Paying Taxes
Important forms for you are:
- Schedule E - Report income or losses annually.
- Schedule D - Report capital gains and loses annually.
Next Steps
Knowing what taxes you’ll be paying as an LLC member is your first step to improving your tax strategy. Use the other tax profiles as a map for navigating better tax treatment. It’s worth mentioning once again: this guide should be considered food for thought and should not be used as the basis for decisions. Please discuss these ideas with your tax professional.
Hopefully this guide has shown how many small business owners are overly exposed to self employment taxes. As you’ve seen there are other options you can consider to significantly reduce your taxes. If you haven’t yet, try our S Corp tax savings calculator to see if your LLC is ready for a new tax strategy.
