Owning an LLC gives you flexibility in how you can be taxed. We cover the pros and cons of each tax status for an LLC.
Aside from limited liability, another major benefit of choosing a limited liability company (LLC) as your business entity is the ability to choose your LLC tax classification. With LLCs, you can decide on your taxation method based on factors such as your goals, business size, and financial plans. Let’s take a look at each tax classification for LLC.
This guide will provide information on how to choose your LLC tax status. However, it’s best to consult a tax professional and do some careful research because, once you set your tax status, you generally have to wait five years before changing it again.
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An LLC, as a business structure, is designed to be flexible. This flexibility is also applied to LLC tax classifications. In selecting your LLC tax status, you can choose one of these tax structures:
By default, LLCs are classified based on the number of members (owners). A single-member LLC is treated as a sole proprietorship and classified as a “disregarded entity” by the IRS, while a multi-member LLC is taxed as a partnership. Either as a sole proprietorship or a partnership, LLCs are treated as a “pass-through” entity unless they choose to be taxed as a C corporation.
Being a pass-through entity means that the business itself typically doesn’t pay federal income tax on its profits. The responsibility to pay income taxes falls only on the individual owner(s). This is unlike a typical corporation, in which profits are taxed at both the business level and the individual owners’ level.
However, an LLC can also choose to be taxed as a corporation. This option is available to both a single-member LLC and a multi-member LLC. Now, this doesn’t change the business structure from an LLC to a corporation. It just dictates how the LLC will be treated for tax purposes.
If you choose to have your LLC taxed as a corporation, you have two options: being taxed as a C corporation (the default form of corporation) or an S corporation. There are very important distinctions between a C corp and an S corp, which we’ll explain later.
Here’s a step-by-step guide to consider when choosing your LLC tax status.
As stated earlier, the major factors most entrepreneurs consider before settling for a tax classification for their LLC include business size, financial plan, and overall members’ goals. So keep those in mind as we briefly discuss each tax classification and the business setup they’re each suited for.
Disregarded entities are the simplest tax classification with straightforward tax reporting. Your LLC is not taxed or required to file a tax return. Instead, the business profits and losses pass to you as the sole owner to be reported on your personal income tax return. For a single-member LLC just starting, it’s often safe to begin with this tax status.
The downside to this tax classification or the partnership classification is that the owner is responsible for paying self-employment tax. The self-employment tax rate is 15.3% and will be reported in addition to income taxes. Self-employment taxes are the taxes that go toward Social Security and Medicare.
The partnership tax classification is quite similar to that of the disregarded entity, except that it’s for LLCs with multiple members. It’s a simple and effective tax structure, which is ideal for a multi-member LLC starting out.
Like a sole proprietorship, the partnership is treated like a pass-through entity, and its members can avoid the “double taxation” of a corporation, in which profits are taxed at both the business and individual owner levels. However, this tax arrangement can prove problematic for LLCs with passive members. This is because each member is responsible for income tax on their portion of the LLC’s revenue, even if they don’t receive distributions.
The S-corp tax structure is not applied by default; business owners have to elect to change their default classification by filing Form 2553. To qualify for S corporation status, an LLC must meet the following requirements, which include having:
An LLC with an S-corp tax classification will not pay federal income tax itself but must file tax Form 1120-S every year. Form 1120S is the U.S. Income Tax Return for an S-Corp.
Even though a traditional LLC already has pass-through taxation, it could still benefit from electing S corp status. It takes a bit of explanation, but it could mean substantial tax savings for some LLCs.
The members of a standard LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by the LLC. Being self-employed means paying self-employment taxes (the taxes earmarked for Social Security and Medicare, which add up to about 15.3%) on all profits they receive from the LLC. This is more than the taxes they’d pay when working for someone else because their employer would pay half of them.
When the members elect S corp status, though, they can be compensated in two ways, by receiving their share of the profits and by being paid as an employee. Once they do that, they only pay employment taxes on their salary and not the profits they receive. (Of course, this is only for the taxes that go toward Social Security and Medicare; LLC members still must pay income and other applicable taxes on their profits.)
One caveat to this is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $1 and avoid contributing anything to Social Security and Medicare. The IRS doesn’t give a precise definition, but it seems to consider “reasonable” to be something similar to what others in your field are earning for the same work.
Another disadvantage to S corporation election is that you’ll need to do payroll for yourself and the other members. If you don’t already have employees you’re doing payroll for, this will be a significant extra hassle and/or expense, depending on whether you do payroll yourself or pay someone else to do it.
If you choose to be taxed as a C corporation (the default form of corporation), you’ll be taxed twice on your profits — once at the entity level and then at the individual level when you file your personal tax returns. Despite this double taxation, certain LLCs may benefit from this tax structure, as it has the most possible deductions. For example, C corporations may be able to deduct the cost of insurance premiums for employees.
LLCs that elect to be taxed as a C-corp must file Form 8832 with the IRS.
When starting an LLC and thinking about tax issues, it’s essential to have your business’s finances organized. We can help with that — our ZenBusiness Money app helps you track and manage all your business finances in one place, so you can serve clients better, collect payments easily, stay organized, and save time and money on taxes.
Disclaimer: The content on this page is for informational purposes only and doesn’t constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
Tax classifications for LLCs are tax structures that determine how the IRS treats an LLC for federal tax purposes. These tax statuses include disregarded entities, partnerships, S-corps, and C-corps.
By default, single-member LLCs and multi-member LLCs are treated as disregarded entities and partnerships, respectively. However, you can also elect to be treated as a corporation (C-corp or S-corp) for tax purposes. What tax classification you choose will depend on your specific circumstances and goals, so talk to your accountant about what would work best for your business.
On a W-9 Form (Request for Taxpayer Identification Number and Certification), you provide your or your LLC’s Taxpayer Identification Number (TIN) or Employer Identification Number (EIN) to the person who is required to file an information return with the IRS to report. The person completing the form will need to indicate whether they or their business is classified as a sole proprietor, LLC, C corporation, S corporation, partnership, trust, or estate.
If you have a single-member LLC, by default the IRS considers you and the business the same entity for tax purposes, so you file your personal tax return alongside your business information on Schedule C. If your LLC is taxed as a partnership, C corporation, or S corporation, you’ll need to file a separate tax return for the business, even if it’s only an informational return.
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