Clearest article I have seen yet:
https://www.corpnet.com/blog/multi-member-llc/#:~:text=By%20default%2C%20the%20IRS%20treats,their%20personal%20income%20tax%20returns.
Digging into Income Tax Treatment
As a multi-member LLC, you have some flexibility in how your business’s income taxes are handled. By default, the IRS treats multiple member-owned LLCs as partnerships. Just like a single-member LLC, a multi-member LLC does not pay taxes on business income. Rather, the owners (members) individually pay income tax, based on their share of the profits, on their personal income tax returns. At tax time, the LLC must file an informational return (Form 1065, with Schedule K-1 prepared for each member), and each member must then report his or her earnings on Schedule E of Form 1040. As is the case with a general partnership, LLC members must usually pay self-employment tax (Social Security and Medicare tax) on their share of the LLC’s earnings.
You have other tax treatment options with an LLC, too.
Members can decide to have the business taxed as a C Corporation, whereby standard corporate tax rules apply. In other words, your company pays income tax on its earnings at the corporate tax rate via Form 1120 (U.S. Corporation Income Tax Return). If you expect you’ll keep a significant amount of your profits in your company, electing corporate taxation may save you and your co-owners some money. By doing so, you and the other owners won’t pay income tax at the individual level on those earnings. To elect C Corp tax status for your multi-member LLC, you must file Form 8832 (Entity Classification Election) when registering your business. Existing LLCs can also use Form 8832 to change their tax status to that of a C Corp.
Your multi-member LLC has the option of S Corporation tax treatment, too. With S Corp status, you are taxed as a partnership would be, with profits and losses passed through to members’ individual tax returns (filed via Schedule E of Form 1040). The difference, however, is that the owners need only pay self-employment tax on their salaries and wages, not on their profit distributions. When filing income taxes, the S Corp must file an informational return (Form 1120S) and shareholders (owners) should report their earnings from the company on Schedule E of their Form 1040. To elect S Corp tax status for your multi-member LLC, you must file Form 2553 (Election by a Small Business Corporation) when registering your business. Existing LLCs can also use Form 2553 to change their tax status to that of an S Corp.
Federal income tax rules can change, so regularly touch base with your tax advisor.
At the state level, tax laws vary for LLCs. Although most emulate the IRS tax rules, I suggest talking with a tax professional to ensure you understand how income taxes will be applied.
Some states levy other fees on LLCs, such as franchise taxes. Contrary to the name, a franchise tax isn’t specific to businesses operating as franchises. It is charged to LLCs, partnerships, and corporations as a fee for the privilege of forming and conducting business in the state. To find out if such a fee or others will apply to your multi-member LLC, contact your state’s Secretary of State office.
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What is “pass-through” tax treatment?
Pass-through tax treatment means that a business entity, such as a limited liability company that chooses this tax treatment, does not pay income tax on its profits. Instead, each of its owner/members reports a percentage share of the profits or losses on his/her individual tax return. Any profits reported this way are taxed based on the owner/member’s tax rate. Limited liability companies have a choice between pass-through tax treatment and corporate tax treatment. In general, if the LLC chooses corporate tax treatment, it will pay tax on its profits and then, if and when it pays dividends to its owner/members, they will have to pay tax on those dividends (a phenomenon often referred to as “double taxation”). However, under certain circumstances, an LLC can qualify to be taxed as an “S corporation”, in which case the double taxation effect is avoided.
Why would an LLC choose corporate (i.e. non-pass-through) tax treatment?
The most common reason an LLC chooses corporate tax treatment is to protect the member/owners from having to pay income tax on profits that are not distributed. This is important in situations where the company wants to retain its profits for future business needs. Another common reason why an LLC might choose corporate tax treatment is particular to small LLCs whose owner/members provide services to the company or its customers. In this situation, if the LLC qualifies to be taxed as an S corporation, electing corporate tax treatment might diminish self-employment tax liability for the owner/members providing these services.
Does an LLC that chooses pass-through tax treatment need to file tax returns?
An LLC is required to file Federal and state tax returns every year even if it opts to be treated as a pass-through entity. The only exception to this rule applies to a “single-member LLC” which can opt to be treated as a “disregarded entity” for income tax purposes. A disregarded entity is not required to file federal tax returns; instead, its member/owner reports the single-member LLC’s income and expenses on his/her personal federal return. In addition to saving time and money, disregarded entity tax treatment allows the member/owner to take advantage of tax benefits not generally available in connection with assets held by an LLC, such as mortgage interest deductions and capital gain exclusions on a home held by a single-member LLC and occupied as a personal residence by the LLC’s owner/member. Note, however, that many states (including California) require single-member LLCs to file state tax returns even if they are not required to file Federal returns.
