A major advantage to forming an LLC is the flexibility of members to choose how they wish to be taxed (if they meet the eligibility criteria).
Because an LLC is a disregarded entity for tax purposes, members can be taxed as a sole proprietorship (for single-member LLCs), partnership, C-corporation, or S-corporation.
The tax classification that you elect for your LLC depends on your long-term business goals, personal liability protection, and your tax strategy.
Small business owners that stay with the default class (sole proprietorship or partnership) report business income on personal tax returns and pay taxes at their respective personal tax rates.
Because individual scenarios vary, it's hard to predict how much federal or state tax you'll have to pay.
This guide will focus on LLC tax classification at the federal level and explain what it means for you.
Table of contents
- Tax classification explained for limited liability companies
- What tax classification should I use for my LLC?
- How to change default tax classification for an LLC
- Conclusion
- FAQ Commonly asked questions
Tax classification for limited liability companies explained
LLCs don’t have a universally required tax classification.
But there are default classifications assigned by the IRS. As an LLC owner, you’re in the capacity to select how you want to be taxed.
How an LLC can be taxed
An LLC is a disregarded entity for tax purposes, so unless you elect to be taxed otherwise, there are two standard tax scenarios for an LLC depending on the number of owners:
- Single-member LLC is taxed as a sole proprietor.
- Multi-member LLC is taxed as a partnership.
Alternatively, LLCs can elect to be taxed as an S-corporation or C-corporation if they meet the federal requirements.
However, this decision has several other operational implications apart from taxation.
For example, you’re then obliged to issue and distribute shareholder stocks to all members. If some of your members are not eligible to hold S-corp stocks, this can create issues.
What taxes does a single-member LLC pay?
If you're a single-member LLC, you're the only owner. So the IRS treats you as a sole proprietor. Your business profits and losses should be included on Schedule C, which will be part of your personal income tax return.
On a state level, you also need to pay any appropriate personal income taxes. And, if bound by the state laws, annual franchise taxes for doing business in the state.
How does a multi-member LLC get taxed?
If you're a multi-member LLC, your default tax classification is a partnership. It means you have to file an informational return with the IRS on Form 1120, and each partner will get a Schedule K-1 that outlines that partner’s share of profits or losses.
Taxable income will be included on each partner’s individual tax returns.
Likewise, each LLC member will also have to pay applicable state taxes on personal income. And your company should foot the franchise tax bill to the state.
Alternative LLC taxation: S-corp and C-corp
You can also choose to be taxed as another type of business entity, such as an S-corp or C-corp.
An LLC can choose to be taxed as an S-corporation (named after Subchapter S of the Internal Revenue Code). To do this, you must elect this status with the IRS on tax Form 2553. With S-corp status, the LLC members work for the S-corporation. Therefore, owners are paid wages.
When you're paid wages, you're not self-employed, so you don't pay self-employment taxes, including social security and Medicare. Any distributions outside of wages, however, will be taxed on your personal tax return.
You can also choose to be taxed as a C-corporation by filing IRS Form 8832. C-corps are subject to double taxation because the business profits are taxed at the corporate level, and those same profits are taxed again when paid to shareholders.
Some think a C-corp is reserved for large, public organizations, but it could make sense for your small business in some cases.
Your tax entity classification election is how the IRS recognizes your business since they don't recognize LLCs.
Regardless of which structure you choose, most states require businesses to select a registered agent. A registered agent is a person or company that can accept legal and tax documents on behalf of your business. The registered agent must have a physical address in the state where your business is registered.
Make sure this is someone you trust because if your business is sued and you get served, this is the person who will receive the service.
If you choose to be your own registered agent, note that (1) your business can’t be a PO box, and (2) that address will become public information.
For example, your home address will become public information if you run a home-based business as part of your annual LLC filing.
Does a multi-member LLC have to file a tax return?
An LLC itself doesn’t file a corporate tax return, but the members will file individual tax returns and pay applicable federal income taxes, according to their income bracket.
What tax classification should I use for my LLC?
If operating as a freelancer or in a low-risk industry, a sole proprietorship may make sense for you as a single-member LLC owner.
Advantages of using default tax classification as a sole proprietor
- No added paperwork or cost
- Owner gets 100% of profits
- The owner makes all the business decisions
Disadvantages of using default tax classification as a sole proprietor
- Sole proprietor assumes all liability for business debts
- No tax benefits or credits
A multi-member LLC is taxed as a partnership by default may be best in certain situations.
Advantages of using default tax classification as a partnership
- Owners' tax rates could be lower than corporate rates
- Avoid double taxation of profits
- No added paperwork
Disadvantages of using default tax classification as a partnership
- Owners must pay self-employment tax
- General partners are liable for business debts
- Potential partner disagreements can disrupt business
Choosing a business structure is a crucial decision for your business. It's best to consult with a CPA or attorney to make an informed choice.
How to change default tax classification for an LLC
You must make the election within 75 days of the LLC's formation date.
Because S-corp election means owners receive wages, it's a good idea to use a payroll service to track wages and payroll taxes withheld. It’s also helpful in case of an audit where you may need to verify salaries paid to owners.
On the other hand, electing S-corp status means that your LLC agrees to issue stock to members. Also, your business doesn’t qualify as an S-corp if you have over 100 members.
Finally, all LLC owners must be US residents. Foreign ownership is not permitted for S-corps.
C-corporation status must also be elected within 75 days of formation. This election means you must govern the business like a corporation and hold annual meeting minutes.
Additionally, C-corp status means double taxation. The advantage, however, is that you can retain more funds in the business and pay yourself annual dividends instead of a fixed salary or self-employment income.
Changing your company's legal tax status is not worth considering if you’re not fully aware of the pros and cons of each. It's also worth exploring as you set goals for the business and look for tax-saving opportunities.
Your state may also impose certain limitations on your business tax status. Check with your secretary of state to make sure your company is eligible for a status change.
Conclusion
Choosing your LLC tax classification is a big decision for your business. Things like ownership structure, asset protection, how you want to manage the business, long-term goals, and tax implications play a role when making the election.
Some tax classes may require more paperwork but lead to a lower tax bill. Others can constrain your business management structure while offering a marginal tax advantage.
Consult with a CPA to discuss the pros and cons of each tax classification to make the right call.
Commonly asked questions (FAQ)
Listed below are frequently asked questions about LLC tax classifications.
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Last updated: Apr 2024