Today, we’ll be discussing how LLCs are taxed. One of the most important terms to understand in order to grasp how taxes work with an LLC is “pass through entity.” In these entities, both profits and losses “pass through” the LLC towards each LLC member. Members then report profits and losses on their own personal tax returns.
This is where things can get tricky since we’re dealing with multiple members.
Multiple member LLCs are treated as partnerships. Each member pays taxes on his/her own share of the profits and losses. The specific share breakdown is based on the distributive share, which should be outlined in the LLC operating agreement.
Distributive shares are usually based on percentage ownership. Thus, a standard 50/50 split is common. However, there are other arrangements. Let’s look at a common example.
Kevin and Steve operate a small surfboard shop. According to their LLC operating agreement, the distributive share allocates 70 percent of profits/losses to Kevin and the remaining 30 percent to Steve. This uneven split accounts for the difference in both the time and money both parties can invest in the shop. Come tax time, Kevin and Steve will report their respective shares on their personal income tax return.
No separate business tax filings are required thanks to the LLC being considered a pass-through entity. Both Kevin and Steve can enjoy the liability protection of an LLC, without having to file taxes beyond their own personal tax return. In addition, both parties can report profits and losses according to a distributive share that accurately reflects their economic situation.
In special circumstances, members may choose what’s called a “special allocation.” This is when LLC members report profits and losses in a way that doesn’t reflect their ownership percentage in the company. With this flexibility, it could be tempting to shift profits and losses in a way that artificially reduces tax liability for certain members. This form of abuse is why the IRS has stringent rules when it comes to meeting LLC special allocation requirements. In fact, special allocations are often rejected.
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