LLC Tax Classification: Everything You Need to Know
All new LLC owners must address LLC tax classification for their business. An LLC can choose to be classified in various ways for tax purposes.9 min read
All new LLC owners must address LLC tax classification for their business. Unlike some other business forms, an LLC can choose to be classified in various ways for tax purposes. The three primary options for LLC tax classification include disregarded entity, partnership, and corporation. Within the corporate classification, two sub-options include C corporation and S corporation. Some of these classifications require forms to be filed with the IRS while others occur by default.
The best classification for the LLC and its owners will depend on a number of factors like business size, members' goals, and financial plans for the LLC. Most people consider personal asset protection, formation cost, management structure, and maintenance requirements when making this decision.
LLC Tax Classification Options
LLCs have multiple options for how they will be classified for tax purposes because they are hybrid entities that combine the advantages of different business forms. LLCs are designed to be flexible entities, and that flexibility carries over to tax classification. Because they are hybrids created by state law, the IRS does not recognize LLCs as distinct, unique types of businesses for tax purposes.
These classifications just indicate how the entity will be taxed. They do not change the type of entity. In other words, electing corporation taxation classification with the IRS does not change an LLC into a corporation. The business is still an LLC for all non-tax purposes, but it is taxed like a corporation. The owners are still called members, the operating agreement is still the governing document, and so on.
- Disregarded Entity. LLCs can be classified as pass-through entities for tax purposes. This basically means they will be treated like sole proprietorships where the LLCs and the owners are considered one-and-the-same for tax purposes. Under this classification, the single LLC owner is basically self-employed for tax purposes and must file and pay the same self-employed tax forms as individuals freelancing or operating a business in their personal name.
- Partnership. LLCs with multiple members can be classified as partnerships for tax purposes. Like LLCs taxed as disregarded entities, LLCs taxed as partnerships are treated as pass-through entities and individual owners are taxed for the LLC's profits and losses. Under this classification, even if LLC owners do not actually receive their percentage of the profits (they are left in the LLC's bank account), they are still taxed on those profits as though they had received them.
Unlike disregarded entity classification, under partnership classification, the LLC itself still has to report certain information to the IRS on its own behalf even though the entity itself is not taxed. The LLC must also prepare certain forms and send them to owners to assist them in their own filings.
- Corporation Classification. LLCs of all sizes, including single-member LLCs, can choose to be classified like corporations for tax purposes. If they choose this option, then both the LLCs and the individuals have reporting requirements. However, if s-corporation status is elected, the corporations will not have to pay federal taxes on profits; instead, they will pass through to the LLCs owners who will include them on their individual taxes.
An LLC treated as a disregarded entity or a partnership must file Form 1065 at tax time and issue a Schedule K-1 to each member detailing his or her share of profits and losses.
Regardless of what classification you choose, funds spent on the business are not taxed. These expenses, which can include start-up costs, travel, equipment, advertising, and other deductible costs, can be "written off," thus lowering the percentage of your income that is subject to income and self-employment tax.
No Impact on Personal Asset Protection
An LLC's tax classification does not impact its limited liability protection. LLCs have the same protection under all classifications that they otherwise would under state law. For example, even though sole proprietorships usually lack limited liability protection for their owners, an LLC that is taxed as a sole proprietorship maintains limited liability protection for its owners.
The LLC still protects its owners' individual assets because they are considered separate from the LLC's assets for legal purposes. Limited liability protection is not absolute protection and under certain circumstances, such as the owner committing fraud through the LLC, LLC owners may still be subjected to personal liability.
Benefits of Corporation Taxation Classification
LLC owners are sometimes reluctant to choose corporation tax status out of fear of double taxation or more complicated filings. However, corporation status is the best option for some LLCs and should be considered. Additionally, competent tax and legal advisors can often help LLCs legally avoid large double-taxation burdens.
LLCs that will often need to maintain substantial profits in their LLC accounts are prime candidates for benefiting from corporation taxation status election. If the LLC retains $75,000 or less in its account, the cost of retaining that money as profits is lower than if it were taxed as pass-through income because tax rates on it are lower than the self-employment tax that would need to be paid.
In addition to the possibility of saving money, LLCs taxed as corporations have options for offering employee benefits like stock option plans that are not available to other LLCs. These incentives can be key recruitment tools when hiring executives and staff for the LLC.
Management structure is the most dramatic difference between an LLC and a corporation and thus must be considered closely. A corporation is comprised of shareholders, directors, and officers, typically including a president, secretary, and treasurer. Corporations must stick to defined rules about the rights, responsibilities, and obligations for each of these roles.
The management structure for an LLC is much more flexible. This type of company can be managed by the members or by managers appointed by the members. You can appoint officers but do not have to do so. LLCs do not have shareholders or boards of directors.
Corporations must also adhere to strenuous recordkeeping requirements that do not apply to LLCs.
Options for LLCs Taxed as Corporations
Most LLCs that elect to be taxed as corporations have a second decision to make: whether to be classified as a C corporation or an S corporation. By default, the IRS will classify the business as a C corporation, but a qualifying LLC can file a Form 2553, electing to be classified as an S corporation instead.
C Corporation. A C corporation is the traditional corporate form that can have as many shareholders or members as desired. C corporation owners are taxed on their personal income taxes for the share of profits they receive from the business. Additionally, the corporation itself is taxed independently of the individual. The main downside of corporations is the possibility of “double taxation” — being taxed on profits at the corporate level and, if a distribution is made, at the individual level.
C corporations file their corporate tax returns on a Form 1120. Their owners are usually paid as any other employees and report their income on a W-2. Owners may also receive distributions independent of their salary and must report those on their individual returns, as well.
Owners should be cautious when deciding how much to pay themselves as a salary. If the salaries are not in line with industry norms and appear to be increasing to avoid paying taxes on corporate income, the IRS has authority to reclassify the salaries as dividend distributions. Dividends are not a deductible expense for the corporation, but the owner receiving them must still pay taxes on dividends they receive.
S Corporation. S corporations are not actually a different type of business entity from C corporations. “S corporation” is simply a tax classification recognized by the IRS.
Corporations that have fewer than 100 shareholders and meet some other requirements (like having members who are U.S. citizens or resident aliens and have only one type of stock) are qualified to file Form 2553 with the IRS choosing to be classified as S corporations. The major benefit of S corporations is that they are treated as “pass-through” tax entities by the IRS. Owners of LLCs taxed as S corporations pay for their percentage share of profits and losses of the LLC on their personal income tax filings. They must pay self-employment tax on earnings. Owners can use LLC losses to offset income they obtain from other sources.
Many S corporation owners employ a tax savings strategy where they pay themselves a salary from the corporation, paying associated employment taxes as they go, and take the remaining profits as distribution. Distribution is not subject to self-employment tax, so owners can save big if they legally and effectively employ this strategy.
Election Timing. An LLC that opts to be taxed as an S corporation must file its election with the IRS either within 75 days of formation or within 75 days of the new tax year. Otherwise, by default, the LLC will be taxed as a C corporation. LLCs are limited in how frequently they can change their tax classification.
Considerations When Deciding. The following are some considerations that business owners can think about when deciding between S corporation and C corporation tax classification status for their LLCs:
- LLC owners cannot use losses to offset other income with C corporations because they are not pass-through entities, so losses remain solely with the LLC.
- Double taxation issues can often be avoided for C corporations classified LLCs by strategically making salary payments to offset the LLC's earnings.
- If salaries are paid at the end of the year in lump sums, rather than through normal payroll processes, owners can be subjected to self-employment taxes.
- The salaries are subject to self-employment taxes as well as income taxes.
How to Select Your LLC's Tax Classification
Default Classifications. If you take no action, the IRS has default rules about how your LLC will be classified for tax purposes based on how many members (owners) it has. By default, multi-member LLCs are taxed like partnerships, and single-member LLCs are taxed like sole proprietorships as disregarded entities. If you select to be taxed as a corporation on your Form 8832 and take no other action, by default the IRS will treat your entity as a C corporation.
Electing a Non-Default Classification. If you do not want the default rules to apply to your LLC, you must file an IRS Form 8832. On the form, you will select how you want your LLC to be classified for tax purposes. In most cases, the form must be filed within 75 days of the LLC's formation, or if that deadline is missed, within 75 days of the next tax year. In limited circumstances, late elections will be honored. Be sure to consult necessary advisors before making your decision and filing your Form 8832 because tax status can usually only be changed once every five years.
Electing S Corporation Status. As mentioned above, if you would like to elect S corporation status for your corporation, you must file IRS Form 2553 with the IRS within the same 75-day timelines as your Form 8832.
Completing Your W-9
A common source of confusion for LLCs is how to properly complete their W-9s based on their tax classification. Fortunately, it's not that hard. All you need to do is follow these simple rules:
- LLCs that are taxed as disregarded entities should check the “individual/sole proprietor” box. Even though they are considered LLCs for all other purposes, they should not check the “limited liability box.”
- LLCs that have elected to be taxed as corporations should check “limited liability company” and write the letter corresponding to their corporation type on the blank next to the box. In other words, C corporations should write the letter “C” and S corporations should write the letter “S.”
- LLCs taxed as partnerships should check “limited liability company” and write “P” in the blank space.
- LLCs that are owned by another business entity are in a complex situation and should ask their tax advisor about filling out their W-9.
- Fill in requested basic information like your name, your LLC's name and address, and sign and date the form.
State Tax Classification for LLCs
Because laws vary so much from state to state, it is hard to provide general guidance on state taxes. However, LLCs should be aware that in addition to their federal tax obligations, they are responsible for completing the pertinent tax forms and paying applicable fees at the state level.
Overall, states tend to follow the classification elected at the federal level, so similar forms are often used. A number of states impose additional taxes and/or fees on LLCs operating within their borders. Consult with your state's tax board or your accountant or tax attorney for guidance on your LLC's state tax and fee obligations.
If you're still confused about what the best tax classification for your LLC is or could otherwise benefit from sound legal advice, you can post your legal need on UpCounsel's platform where UpCounsel's network of experienced attorneys can find it and offer their assistance.