LLCs and Taxation

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Many of my clients are curious about forming LLCs and how they are treated for tax purposes.  In Colorado, a limited liability company is considered to be a pass-through entity and is treated like a partnership or sole proprietorship for tax purposes. All of the profits and losses of the LLC pass through the business to the LLC members (owners) who then report this information on their personal tax returns. The LLC itself does not pay federal income taxes.  

If the LLC is owned by a single member, the IRS treats it as a sole proprietorship for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS. The sole owner of the LLC reports all profits or losses and submits it with his or her 1040 tax return. If the company makes a profit, even if the member leaves this money in the company, he or she must still report this and pay taxes on this money at the end of the year.

If the LLC is a multi-member LLC, the IRS treats it as a partnership for tax purposes. This means that multi-member LLCs do not pay taxes on business income. Instead, the LLC members each pay taxes on their share of the profits on their personal income tax returns. The LLC members’ share of profits and losses, called a distributive share (usually ownership percentage), should be set out in the LLC operating agreement.

Most operating agreements provide that a member's distributive share is in proportion to his or her percentage interest in the business. If the members decide to split up profits and losses in a way that is not in proportion to the members' percentage interests in the business, it's called a special allocation. The IRS has guidelines as to how this works.

The IRS treats each LLC member as though the member receives his or her entire distributive share each year. This means that each LLC member must pay taxes on his or her whole distributive share, whether or not the LLC actually distributes all (or any of) the money to the members. The practical significance of this is that even if LLC members need to leave profits in the LLC, each LLC member is liable for income tax on his or her rightful share of the profits left in the company.

As a result, if the members intend to keep a substantial amount of profits in the LLC (retained earnings), the members might benefit from electing corporate taxation. Any LLC can choose to be treated like a corporation for tax purposes by filing a form with the IRS within a certain time frame of the LLCs formation.