Here is the legal:
The Internal Revenue Service (IRS), by default, treats a single-member LLC as a sole proprietorship, and all of its profit is considered the owner's income. A multi-member LLC, by default, is classified as a partnership, and the LLC's operating agreement determines the percentage of income shared by each member. The LLC can distribute income disproportionate to the capital investment of each member. For instance, to compensate a member responsible for the daily running of the business, that owner may receive 70 percent of the profit even though the ownership interest in the LLC is only 30 percent.
The LLC itself pays no taxes. Instead, each member's share of profit, if any, is subject to personal income tax, whether the profit is distributed or not. Member managers, those members who actively participate in the operations of the business, also must pay self-employment (SE) tax on their share of profit. A passive member, the LLC equivalent of a limited partner, does not actively participate in the business operations and reports profit as passive income not subject to SE tax.
An LLC can elect to change it's tax classification to that of an S corporation. Under this classification, member managers must be paid a "reasonable wage" that meets the standards of the industry in which the LLC operates. Instead of self-employment tax, the wage is subject to payroll taxes paid by the LLC and standard personal income tax. However, a member manager also may receive a share of profit separate from the wage that is reported as passive income, which can represent a significant tax savings if profits are high enough. Wages are counted as business expenses, and all income and expenses for the business are divided among the members and reported on personal tax returns. The division of income, however, is based on the percentage of ownership of each member.
An LLC also may elect to be taxed as a C corporation, which allows the company to not attribute a portion of its profit to any member. Under this classification, member managers still must be paid and profit shares are distributed in proportion to each member's percentage of ownership. However, if members decide not to distribute the entire profit, the undistributed portion is not subject to personal income tax. An LLC taxed as a C corporation must pay a corporate tax on its entire profit and each member reports the share of distributed profit as passive income, the so-called "double tax" that C corporations face. Undistributed profits still may represent a tax savings by not pushing a member into a higher tax bracket if profits are high enough.
Legal Status Unchanged
Despite the ability of an LLC to choose how it can be taxed, the legal structure of the LLC remains unchanged. There is no limit on the number of members it can have, as there is with shareholders of an S corporation. Members can be individuals or other business entities. Though tax reporting becomes more complex when taxed as a corporation, the LLC avoids the additional paperwork and state reporting requirements imposed on corporations. However, once an LLC elects to change its classification, it can't change again for five years unless the majority of current members were not owners when it was formed.
