LLC Classification

LLC classification refers to how limited liability companies are classified by the IRS for tax purposes. This is a subject that must be addressed by anyone forming an LLC. LLCs are mainly classified in three of the following ways for tax purposes:

  • Disregarded entity
  • Partnership
  • Corporation
    • C corporation classification
    • S corporation classification

The type of classification has no effect on the type of entity overall—they all remain LLCs. However, some LLC classifications will require certain IRS forms to be filed, while others will not. What classification you choose depends on what you feel is best for your LLC, which will depend on such factors as the size of the business, the goals of the LLC members, and the LLC’s financial plans.

Disregarded Entity Classification

Disregarded entities are single-member LLCs where, for tax purposes, the owner is considered self-employed. The owner is required to file self-employment tax forms as a freelancer or as an individual running a business in their spare time.

Such an LLC is referred to as a pass-through entity. This means the LLC is treated as a sole proprietorship, and for tax purposes, the owner is considered the same as the business.

Partnership Classification

If an LLC is multi-member, it can be classified as a partnership. If so, it is treated as a pass-through entity in which the individual owners will be taxed for the losses and profits of the LLC even if they do not receive those profits in their bank accounts. Since the profits and losses go to the individual owners, the LLC will not be taxed by the IRS, but it still must report certain information. Additionally, it is necessary for the LLC to send certain forms to its owners for the benefit of their IRS filings.  

Corporation Classification

For tax purposes, any LLC can be classified as a corporation. A corporation is a legal entity meant to be separate under state law to protect the owner’s assets from creditors. If you choose this classification, both you and the LLC will have to meet certain reporting requirements. Some LLC owners can be reluctant to elect the corporation status due to fears of double taxation, but professional tax advisors can help you reduce it. Within the corporation classification, there are two sub-groups: C corporation and S corporation.

C Corporation Classification

This is the default classification the IRS gives to LLCs that elect corporation status, and it is the most common form for LLC corporations with many members. In such cases, LLC owners benefit by having their LLC profits taxed as personal income while the corporation is taxed separately. For smaller businesses, however, C corporations are not as popular because of double taxation.

A C corporation may be appropriate if you:

  • Anticipate needing venture capital financing.
  • Desire flexible profit-sharing.
  • Want your LLC earnings to stay in-company.
  • Desire flexibility for spreading business earnings amongst shareholders and the corporation.
  • Desire flexibility when it comes to salaries in order to reduce Medicare and Social Security taxes.
  • Desire flexibility to give substantial medical and other benefits to your employees.
  • Desire ease in selling your LLC.
  • Wish to offer stock options to your employees.
  • Think your LLC will own real estate.
  • Wish to reduce the odds of an IRS audit, since those who file business income only on their 1040 have a higher audit rate.

S Corporation Classification

The S corporation classification is for LLCs with one class of stock and less than 100 members, all of whom are U.S. citizens/resident aliens. To elect it, you must file Form 2553 with the IRS.

LLC owners file their LLC losses and profits on their personal tax filings, and their earnings are subject to self-employment tax. However, LLC losses can be used to offset income received from other sources. Also, S corporation owners can reduce their taxes by paying themselves a corporate salary, paying associated employment taxes, and receiving the rest of the profits in the form of a distribution.

The S corporation may be appropriate if you:

  • Wish to receive the corporate benefits this classification has while also having pass-through taxation.
  • Desire flexibility when it comes to salaries in order to reduce Medicare and Social Security taxes.
  • Desire flexibility for accounting methods, since S corporations don’t have to use accrual accounting if they don’t have inventory.
  • Desire lower IRS audit risk, since those who file business income only on their 1040 have a higher audit rate.

How to Select Your LLC’s Tax Classification

If no action is taken on your part, the IRS will select your classification based on the LLC's membership size. To avoid this, file Form 8832 with the IRS within 75 days of LLC formation, or within 75 days of the following tax year if that deadline is missed. However, before you make this decision, you should consult professional advisors, as this election can normally only be changed every five years.

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