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LLC Majority Owner Income Tax Implications

The income tax implications of using a limited liability company, or LLC, for your business are very different than most other types of business entities. The IRS doesn’t tax all LLCs in the same way. Instead, it allows members to choose from various income tax treatments. Both majority owners and other LLC members are taxed in the same way; however, it’s the majority owners who bear the financial burden of the chosen income tax treatment that’s elected for the LLC.

Initial LLC Tax Treatment

Immediately after forming an LLC, there are default income tax designations that apply. If an LLC has only one member, the IRS imposes tax as if the single member is a sole proprietor. When two or more LLC members exist, partnership tax rules automatically apply. However, members of the LLC can choose an alternate designation. If members agree, an election can be made on Form 8832 to tax the LLC like a corporation. Once an election is filed, it is binding on the LLC for five years. After this 5-year period, it can go back to its original designation as a partnership or sole proprietorship. And although every LLC member must adhere to the same income tax rules when reporting LLC income on their personal tax returns, a majority owner can usually exert more influence over the decision as to how the LLC should be taxed.

LLC Operating Agreements

The tax implications of the LLC’s earnings on majority owners are also impacted by the LLC’s operating agreement. The operating agreement governs how the LLC is managed, sets forth restrictions on the types of transactions the LLC may engage in and how LLC profits and losses are allocated. Profit and loss allocations in the LLC operating agreement will state what each member’s share of profits are. For tax purposes, these allocations directly impact how majority owners, as well as other members, will report their shares of profits and losses on a persona tax return.

Form 8832 Elections

When the LLC doesn’t elect corporate treatment on Form 8832, each member reports their respective share of LLC earnings and losses on a 1040 in the same way that partners in a partnership do. This requires reporting all LLC income on a Schedule E attachment to the 1040. In addition, the LLC files a partnership tax return on Form 1065 and prepares a Schedule K-1 to report each member’s profit allocation as stated in the operating agreement.

An LLC that makes an election on Form 8832 for corporate tax treatment instead reports and pays income taxes on all LLC earnings on Form 1120, the corporate tax return. One disadvantage to corporate tax is that it imposes double taxation, which for a majority owner can be a significant amount of money. The reason is because the LLC makes profit distributions to LLC members from the after-tax earnings, or in other words, whatever is left after paying the corporate income tax of approximately 35%. A second tax is then due from each member in the year they take a profit distribution from the LLC. Ultimately, this increases the effective tax rate that the LLC pays on its earnings.

Reference: IRS Publication 3402-Taxation of Limited Liability Companies