A limited liability corporation (LLC) is a special type of business association that shares characteristics of C corporations and partnerships. Like a C corporation, the owners of an LLC have limited liability in terms of debt and legal liabilities. Like a partnership, the owners of an LLC enjoy pass-through taxation. Because corporate earnings and personal earnings are taxed differently, it is important for LLC owners to distinguish between retained earnings and regular income.
A significant advantage of the LLC business format is that this legal structure avoids double-taxation. In a corporation, income is taxed at the corporate level and then at the shareholder level. In an LLC, however, income is taxed only once, when it passes through to the owners of the LLC and is treated as ordinary income.
Regular Income Tax
The Internal Revenue Code has a variety of tax rates on different types of income. Currently, the top tax rate for individual income is 35 percent. This is the maximum rate that the owner of an LLC would pay on income generated by that company. For a highly profitable company, it is likely that a significant portion if not a majority of the owners' income would be taxed at this rate.
While C corporations face double-taxation, the first round of taxes is based on the corporate tax rate of 15 percent. This is significantly lower than the 35 percent maximum tax rate for individual income taxes. Therefore, LLCs would benefit if some of their earnings could be treated as corporate earnings, rather than individual income.
Generally, the income of an LLC is treated as personal income for the owners. However, there may be instances when an LLC wishes to retain some income for a later year to save up for a large purchase, for example. In this situation, the LLC may be able to treat these retained earnings as corporate profits rather than personal profits. To do so, the LLC must file a Form 8832 with the Internal Revenue Service stating its intention to have retained earnings taxed at the corporate rate.