By Jason Watson (Google+)
This KB article has been superseded. Please see our updated articles.
It depends. Single-member LLCs are taxed similarly to sole proprietorships, and multi-member LLCs are taxed similarly to partnerships. Since a single-member LLC does not file a corporate tax return on Form 1065 there is not a K-1 associated with this business, and therefore the income flows directly onto the owner’s personal tax return on Schedule C. This in turn triggers self-employment tax (currently 15.3% for 2013).
Multi-member LLCs (yes, a husband and wife count as two members according to IRS code) must file a corporate tax return on Form 1065 and distribute K-1s to the members (owners). A K-1 is a statement that each owner receives, and it is similar to a W-2 since it shows the income that each owner is responsible for from a taxation perspective.
And if you materially participated in the managing of the business, your K-1 will be subjected to self-employment tax AND income tax. Self-employment tax is current 15.3% for 2013 and income tax can vary between 10% and 39%. You could easily pay 25-54% in taxes on the income produced by an LLC if you elect to be treated as a sole proprietorship or partnership- this is certainly not desirable (keep reading).
And forming an LLC might subject your business to additional state taxes. Certain states (California and New Jersey for instance) subject LLCs to franchise taxes in addition to a typical income tax.
However, there are two caveats with this- an LLC with the S-Corp election can avoid a large portion of the self-employment tax (see Is there a way to avoid self-employment tax?) which can offset some of its inherent costs. And income generated from an LLC that owns rental properties is simply not subjected to self-employment tax since it is rental (passive) income.
You can also read our tax article on the S-Corp election which expands on the self-employment tax issue at-