LLCs and Sole Proprietorships

Over the past few years, an increasing number of Bay Area workers have embraced the gig economy and begun operating their own businesses as either limited liability companies (LLCs) or sole proprietorships. These businesses must collect and report comprehensive tax information each year.

Federal Taxation of LLCs

LLCs blend corporate and partnership business structures and are formed by registering a company as an LLC with the California Secretary of State. Once formed, the LLC can elect to be treated as a corporation, partnership, or a single-owner “disregarded entity.” A disregarded entity is not taxed as a business that is separate from its owner. These are also known as single-member LLCs.

For federal tax purposes, an LLC with at least two members will be classified as a partnership unless it elects to be treated as a corporation. If the LLC has been classified as a partnership, it must file its annual returns on a Form 1065, U.S. Return of Partnership Income, with each owner reporting their share of the partnership’s income, deductions, and credits on a Schedule K-1 (1065), Partner’s Share of Income, Deductions Credits, etc. When an LLC files as a partnership the partners pay the self-employment tax due on their share of the company’s earnings.

When an LLC elects to be treated as a corporation, the IRS will treat it in the same manner as a C corporation and the company will be required to file an annual Form 1120, U.S. Corporation Income Tax Return, and pay the corporate income tax. An LLC may also choose to be classified as an S corporation and will be treated as a pass-through entity that pays no tax, but it must still file a Form 1120S, U.S. Income Tax Return for an S Corporation. Each owner of the S corporation must report their share of the corporation’s income, credits, and deductions on a Schedule K-1 (Form 1120S).

The business activities of a single-member LLC not taxed as a corporation should be reported on the owner’s federal income tax return. Those business activities are usually reflected on the owner’s Form 1040, Individual Income Tax Return, or Form 1040 Schedule C, Profit or Loss from Business (Sole Proprietorship). However, a single-member LLC that has been classified as a disregarded entity will be treated separately from its owner for employment tax purposes and for certain excise taxes.

California’s Taxation of LLCs

California’s LLCs must be classified in the same manner as they are for federal tax purposes. Therefore, an LLC may be classified as a corporation, partnership, or a single-member disregarded entity. Even if an LLC is not doing business in California, it must pay an annual $800 tax until the LLC is canceled with the Secretary of State.

LLCs that make more than $250,000 in a year must pay an annual fee that increases with the amount of income they earn that is based on the following schedule:

• $250,000-$499,999: $900
• $500,000 to $999,999: $2,500
• $1 million to $4,999,999: $6,000
• $5 million or more: $11,790

The LLC must also file an annual Form 568, Limited Liability Company Return of Income. If the LLC has earned income–or incurred a loss–outside of the state, it must determine how much income must be allocated to California.

Federal Taxation of Sole Proprietorships

When a business chooses to operate as a sole proprietorship, its owner must report all of his or her business income or losses on the owner’s personal income tax return because the business is not taxed separately by the IRS. The owner will report the business’s profit or loss on his or her Form 1040 Schedule C and will pay income tax on all of the business’s profits. Sole proprietors may also deduct their business expenses like any other business.

The 2017 Tax Cuts and Jobs Act added a new deduction, which could benefit some sole proprietors. The new pass-through tax deduction allows up to 20% of a sole proprietor’s net business income to be deducted as an additional personal deduction. However, if the sole proprietor earns more than $157,500 annually ($315,000 if married filing jointly), he or she must have employees or depreciable business property to take advantage of the deduction and the deduction is capped at the cost of the business property or a percentage of employee wages. The deduction is also not available for sole proprietors providing some types of personal services with incomes in excess of $207,500 ($415,000 if married filing jointly).

Sole proprietorships are required to make quarterly estimated tax payments to the IRS that are based on estimates of the tax the owner will owe at the end of the year. Additionally, they must pay the 15.3% self-employment taxes to fund the Social Security and Medicare systems.

California’s Taxation of Sole Proprietorships

In California, sole proprietorships are required to report all of their business income or losses on the owner’s Form 540, California Resident Income Tax Return. The owner’s business income and expenses should be reported on the IRS Form 1040 Schedule C. Sole proprietors are also expected to pay estimated taxes to the state and apportion their business income.

Additional Questions About LLC or Sole Proprietorship Taxation?

The skilled business tax professionals at Code Accounting are ready to answer any questions you may have about your business’s state and federal tax obligations. We have the experience in preparing and filing state and federal returns for LLCs and sole proprietorships necessary to ensure that your business is tax compliant. Code Accounting can also provide your business with tax advice to ensure that you will not be facing any unexpected bills due to poor planning.

Categorised in: Planning, Taxes

This post was written by Sean Allaband