Limited liability companies (LLCs) are one of the most popular types of business entities. What they are not is a tax classification. In fact, an LLC’s flexible taxation options are one reason it is the preferred choice of enity; LLC members can, for the most part, choose how they would like to be taxed. The LLC enjoys this flexibility because the Internal Revenue Service does not recognize it as a distinct entity for federal tax purposes. It must, therefore, be taxed as one of the four taxable options already available:
- Disregarded Entity. A disregarded entity is a business structure that is not recognized as distinct from its owner for tax purposes. If you are the sole owner of a single-member LLC, the IRS classifies your company as a disregarded entity by default and taxes the LLC as a sole proprietorship. As a result, the owner of a single-member LLC must report the LLC’s income and expenses on the member’s Form 1040 Schedule C. A separate tax return for the entity is not required.
- Partnership. When an LLC has multiple members, the IRS’s default classification for tax purposes is the partnership. Partnerships, like disregarded entities, pass their income and expenses down to their owners, and LLC members are responsible for paying taxes proportionate to their ownership interests. Income, credits, and deductions are reported to the IRS using Schedule K-1 (Form 1065).
- Corporation. If the member or members of an LLC don’t want it to be taxed as either a sole proprietorship or a partnership, they can elect to have it taxed as a corporation by timely filing Form 8832. Electing taxation as a corporation may be beneficial in several ways. If the company does not intend to pay out dividends, electing to file taxes as a corporation allows LLC members to avoid reporting the business’s income on their personal income tax returns. Because personal income tax rates are often higher than corporate income tax rates, this may allow individuals to benefit from the lower corporate income tax rate. Additionally, LLC members may avoid paying self-employment taxes. Thus, corporate taxation may have money-saving benefits for LLC members.
- S Corporation. The S corporation tax election is unique. Unlike the other three options described above, the S corporation is not a different entity type. Rather, it is a corporation that meets all of the following criteria:
- it has less than 100 owners
- all of its owners are United States citizens or residents
- it has only one class of membership
- its membership is not comprised of any partnerships, corporations, or non-resident aliens
If members choose to have their LLC taxed as an S corporation, the LLC members enjoy pass-through taxation unlike a standard corporation. Moreover, the income that is taxed as a distribution is not subject to self-employment tax. Finally, an S corporation allows its owners to take advantage of the Qualified Business Income Deduction of up to 20 percent. There are some limitations as to which industries qualify for this unique deduction. You must timely file IRS Form 2553 to elect S corporation taxation.
We Can Help
Choosing the right structure for your business can be challenging and involves all kinds of considerations in addition to how the LLC should be taxed. Be careful you don’t willy nilly allow the IRS tail to wag the LLC dog. Have a conversation or two with your attorney and your CPA (you do have a CPA, don’t you?), then make the tax decision.
