More entrepreneurs are selecting LLCs over other business structures when they start their companies.
An LLC gives its owners (called members) ease and flexibility in running their new business, extends extra protection over personal assets, and diminishes personal liability.
However, new LLC owners must also keep in mind the business tax implications of having an LLC. Depending on the number of members, the IRS will treat a multi-member LLC as a partnership by default. A corporation status (S-corp or C-corp) is also available if the members make the appropriate election.
Either way, Limited Liability Companies taxed as a partnership or corporation are required to file a separate tax return on Form 1120 for federal tax purposes.
For federal income tax purposes, a single-member LLC is treated as a disregarded entity.
Table of contents
- What does a “disregarded entity” mean for an LLC?
- How single-member LLCs pay federal taxes
- Pros and cons of being a disregarded entity
What does a “disregarded entity” mean for an LLC?
The “disregarded entity” status describes how the IRS classifies the LLC. The federal tax authorities don’t have a specific tax treatment policy for LLCs.
Essentially, they overlook this business structure. And instead, assign a default tax classification of “sole proprietorship” to all single-member LLCs.
That means that the IRS doesn’t tax the LLC itself. Instead, the LLC’s income or loss is taxed on the owner’s individual income tax return, generally on Schedule C included with Form 1040. The disregarded entity status doesn’t impact any operations or personal liability protection of the LLC.
Can an LLC owned by husband and wife be a disregarded entity?
If a married couple jointly owns an LLC, they can elect to treat the LLC as a disregarded business entity for federal income tax purposes.
It’s called a Qualified Joint Venture, an arrangement where both spouses file Schedule C’s and split the net income of business between them.
This election is only available for married couples who meet the following criteria:
- Live in a community property state
- The two spouses are the only owners
- The business isn’t taxed as a corporation
How single-member LLCs pay federal taxes
By default, a single-member LLC is treated as a sole proprietor for federal income tax purposes.
It’s a scenario where LLC is viewed as a “disregarded entity” and not considered separate from the owner. The owner will have to pay self-employment taxes on the profits they draw from the company. LLC members are also allowed to subtract business expenses and claim applicable tax deductions.
All LLC profits and expenses have to be reported on the individual income tax return. The taxes are due on the net profit sum.
S-corporations provide tax savings for LLC members since they don’t have to pay self-employment tax. Members of an S-corporation are considered employees of the entity. Instead, they pay payroll taxes and personal income taxes on the obtained income as other employed taxpayers do.
A domestic LLC with at least two members by default is classified as a partnership for federal income tax purposes. Like single-member LLCs, multi-member LLCs can also elect to be treated as either a C-corporation or S-corporation by filing the appropriate forms with the IRS.
An LLC being taxed as a corporation means LLC members are technically employees who earn W-2 income with Social Security and Medicare taxes withheld from wages.
As a C-corporation, you’re also bound to pay corporate income taxes on all business profits and then personal income taxes on any distributed profits. It’s called double-taxation.
Is LLC or S-Corp better?
An S-corporation is simply an LLC with a different tax classification. At the same time, an LLC is a type of business structure that provides flexibility and personal liability protection for its owners.
Electing S-corp status is one of the legal ways to lower your tax liability without making any changes to your business.
What if my single-member LLC has employees?
Any entity that hires employees must have an Employer Identification Number (EIN). Single-member LLCs often use the owner’s social security number to report taxes, but an EIN is mandatory if you plan to hire employees.
Employers must provide annual Form W-2 to tax authorities. They must also withhold and pay payroll taxes. It can get complicated for owners who are also employees. Owners must be careful when determining how much to pay themselves so that it’s reasonable – and legal. Your salary must be comparable to other businesses in the same industry.
LLC members can elect S-corp status to simplify the employment aspect. This is where a CPA is valuable as they can help you with setting pay and saving on LLC taxes without disrupting your operations.
Pros and cons of being a disregarded entity
Every business decision has a tax effect. Many business owners seek out the simplest and most tax-saving way to run their small businesses.
Here’s a summary of things you need to consider as you decide whether a disregarded entity status works for you.
- Simpler tax filing. With a disregarded entity, there’s no need for the LLC to file additional tax forms. It’s one less thing you have to do as a business owner.
- Pass-through taxation. If you choose C-corporation status for your LLC, you’ll have to deal with double taxation – paying corporate tax on profits and paying again once those same profits are distributed to shareholders. The LLC’s profit or loss for the year is included on Schedule C of the owner’s personal income tax return.
- Personal liability protection. In this status, all the benefits of operating an LLC are still intact, including the owner’s personal asset protection. In the event of your business being sued, your personal assets remain protected from business litigation.
- Self-employment taxes. Being taxed as a sole proprietorship means you’re subject to self-employment taxes on top of personal income taxes. It’s great that self-employment tax is 50% deductible, but what if choosing a different election helps you avoid self-employment tax altogether? These decisions are not to be taken lightly, and you should consult with a tax professional to fully understand your tax situation.
- Employment taxes. Hiring employees (not contractors) for your LLC means you’re on the hook for payroll taxes. You must also file payroll tax returns and issue annual W-2s on time to avoid IRS penalties. Employment taxes can be tricky for LLC members who choose to become employee-owners. You’ll save on self-employment taxes but still have to pay taxes in other areas.
Related: LLC Pros and Cons Explained
A disregarded entity is a status single-member limited liability company receives from the IRS. It means your business is not a separate taxable entity.
However, this classification doesn’t change your status as an incorporated business structure. The LLC remains a separate entity, but business profits, losses, gains, and losses are included in the owner’s personal tax return.
It’s an easy and convenient tax status for new entrepreneurs. As your business grows, consider converting to an S-Corp for tax savings. But be ready to deal with more paperwork.
Whatever you decide, make sure you consult with a CPA or attorney to make the best decision for you and your business.