Why Do LLCs Pay No Income Taxes?

Most limited liability companies (LLCs) pay no income tax.  Why? Because they are “pass-through” entities for income tax purposes, meaning that an LLC’s income, gains and deductions are reported by the LLC members on the members’ tax returns, with the members paying any income taxes that are owing.  Thus, most LLCs must file income tax returns but will not pay any income tax. 

LLCs with 2 or more members are taxed as partnerships.  Partnerships are treated as “pass-through” entities for income tax purposes.  This means that they must report their income to the IRS but do not pay any tax on that income.  Instead, the LLC members each pay their shares of the tax.  Generally, an LLC member’s share (percentage) is defined in the LLC Operating Agreement.  Each year, when the LLC’s income tax return is filed, each LLC member receives a form (Schedule K-1) that shows the member’s share of the LLC’s profits, losses, gains and credits for the year to enable the member to prepare his/her own income tax return.

LLCs with only 1 member are “disregarded” entities for tax purposes. Thus, they do not file any income tax return and pay no income tax. Instead, all income, gains and deductions of a 1-member LLC are reported directly on the member’s own income tax return.

CAUTION:  Each LLC member will be taxed on his or her share of the LLC’s income even where no cash is distributed to the member by the LLC.  A frequent question is: “How come I have to pay tax on income I never received?”  The simple answer is that since an LLC pays no tax, the members must pay the tax on the LLC’s income.  And, even though the LLC may choose to retain and reinvest its income, nevertheless, the income was received and must be taxed to its members. Members could have cash-flow problems if the LLC’s income is not distributed. Often, an LLC will distribute enough cash to its members to enable them to pay their taxes on the LLC’s income.

In addition to federal tax returns, the LLC and its members may be required to file a tax return with each state in which the LLC does business or holds property, with the members paying any state tax that is owing on such income.

There is an exception to the “pass-through” treatment of LLCs for tax purposes.  Each LLC, upon formation, may elect to be taxed as a corporation for income tax purposes instead of being taxed as a partnership or as a “disregarded” entity.  That election is made on a special form that must be filed with the IRS.  Few LLCs ever make this election since corporations do pay income taxes.  Special care and advice is needed in this area.

To receive all of the benefits of using the LLC form, advice and assistance from a competent lawyer is essential.