A limited liability company (LLC) is a popular form of organization for small businesses. LLCs are organized under state laws to provide its owners (called members) protection of their personal assets from business creditors. Even though the formation of a LLC is relatively simple, the tax rules can be complicated.
To start with, LLCs do not pay taxes. They are pass-through tax entities similar to a proprietorship, partnership or S corporation. Each member reports and pays taxes on LLC income on their personal state and federal tax returns and are responsible for filing and paying quarterly income taxes. Losses are also passed through to members and claimed on their tax return. The percentage of income or loss allocated to each member is stated in the LLC operating agreement. However, a LLC can distribute profits and loses disproportionately if it meets certain technical rules. This is called a special allocation. To claim a loss the member must have an active role in the organization and not be a passive investor. In a single member LLC all profits or losses will pass through to the sole owner
LLCs will be classified as a sole proprietorship or partnership for tax purposes based on the number of members. These are called default classifications. LLCs with one member will be classified as an entity disregarded from its owner (the technical term for a sole proprietorship). LLCs with two or more members will be classified as a partnership. An election can be made by any LLC to be taxed as a corporation. In general, the tax laws and regulation as determined by your filing classification must be followed. Federal and California tax laws are similar but each has different reporting requirements.
Federal Tax Reporting Requirements
LLCs with one member will have a default classification as an entity disregarded from its owner (a sole proprietor). Its income, deductions, gains, losses and credits are reported on the one or more of the following schedules to be filed with the owners Form 1040:
• Schedule C, Profit or Loss From Business (sole proprietor).
• Schedule C-EZ, Net Profit or Loss From Business (sole proprietor)
• Schedule E, Supplemental Income or Loss.
• Schedule F, Profit or Loss from Farming
LLCs with two or more members will be classified as a partnership and have the same reporting and filing requirements as any partnership entity. It will file Form 1065, U.S. Partnership Return, and issue each member a Schedule K1 showing the their share of LLC's profits or loss. The member reports the amount on their individual tax return.
LLCs classified as a disregarded entity or partnership can elect to be classified as a corporation. This is accomplished by filing Form 8832, Entity Classification Election, a copy of which must be attached to the Federal income tax return of each member. Corporations are taxpaying entities and as such profits and losses are not allocated to the members.
California Reporting Requirements
LLCs that organize in California, register in California, or conduct business in California are required to meet the following reporting requirements:
• LLCs must conform to the same classification used in their Federal tax returns.
• LLCs classified as partnerships or disregarded entities, are required to file California Form 568, Limited Liability Company Return of Income. California Form 568 must be filed by the 15th day of the 4th month after the close of the LLC’s taxable year. Form 568 has the instructions for reporting the distributive share allocated to each member.
• LLCs required to file Form 568 must pay an annual tax of $800, and also be subject to a fee based on total income from all sources derived from or attributable to the state of California. The annual tax is due by the 15th day of the 4th month of the taxable year, and is paid using CA Form 3522, Limited Liability Company Tax Voucher.
• In addition, LLCs filing Form 568 that has members who are not residents of California must file FTB 3832, Limited Liability Company Nonresident Members' Consent with Form 568. FTB 3832 is signed by nonresident members and foreign entity members to indicate their consent to be under California’s jurisdiction to tax their distributive share of income attributable to California sources. For every nonresident member who did not sign a FTB 3832, the LLC must pay the tax.
• LLCs classified as corporations must file CA Form 100, California Corporation Franchise or Income Tax Return. The California Form 100 needs to be filed by the 15th day of the 3rd month after the close of the LLC’s taxable year.
• The LLC will be taxed at the current corporate tax rate and will be subject to a minimum tax of $800.
• If an LLC does not file Form 568 and/or does not pay all tax, penalties, or interest due, its powers, rights, and privileges may be suspended.
The above is not intended to be comprehensive. Its purpose is to give some understanding of the complexities of LLC taxation. Each LLC is unique. It is advised that you review the tax situation with a tax professional. A tax professional can help with the filings and prevent the LLC from being suspended and its members from being audited or paying interest and penalties for noncompliance. Keeping your LLC active and in compliance with tax laws can provide the needed protection not only for you but also your family.