Tax Classification For LLC: Everything You Need to Know
Once a business owner decides that he or she wants to structure their business as an LLC, the next step is to decide how they want their LLC to be taxed.3 min read
Tax Classification for LLC
A limited liability company, or “LLC,” has become an increasingly popular choice of business structure by business owners looking to start their company, mainly because of the tax classification for LLC. It also provides its owners with protections against personal liability, without all of the regulatory formalities of a corporation. These formalities are often quite burdensome for business owners who are just starting out.
How are Limited Liability Companies Taxed?
Once a business owner decides that he or she wants to structure their business as an LLC, the next step is to decide how they want their LLC to be taxed. This is an important decision, especially if the tax classification of an LLC is what appealed to you in the first place.
LLCs are regulated and registered with the state government, as opposed to the federal government. As such, there are some flexible choices when deciding how to be treated for federal tax purposes as an a LLC. For instance, if the LLC has a single owner, the owner can choose to have the LLC be taxed as if it were a sole-proprietorship. If there are multiple owners, they can choose to have the LLC be taxed as either a corporation or a partnership.
There is no such thing as an “LLC taxation” class. Thus, while the ability to choose how you would like the LLC to be taxed is generally seen as a good thing, you should still take the time to objectively choose which category is best for the company. The Internal Revenue Service (“IRS”) recognizes four business structures, any of which an LLC owner may choose to be taxed like:
Advantages and Disadvantages of Being Taxed Like a Corporation
One of the benefits of choosing to tax an LLC as a corporation is that the LLC’s owner does not have to report the LLC’s profits on his or her personal tax returns. Instead, those profits can be left in the business as separate. The corporate tax rate is also lower compared to the tax rate for a sole-proprietorship or partnership.
On the other hand, a corporation will also be subject to what is called a “double taxation.” This means that the owner is required to pay taxes on the corporation’s income as well as any income he or she received on the dividends the corporation paid out. An LLC is not subject to such a double taxation.
Advantages and Disadvantages of Being Taxed Like a Sole-Proprietorship
If the LLC has only one owner, that owner can elect to be treated like a sole-proprietorship for federal tax purposes. One of the advantages of choosing to be taxed as a sole-proprietorship is that the owner will not be subject to the double taxation described above. Instead, it will be treated as a “pass through” entity. This means that the owner only pays taxes on the business once, and must report the LLC’s income on his or her personal tax returns. The owner and the sole-proprietorship are essentially treated as the same legal entity.
However, there are additional taxes the owner must pay if he or she elects to be treated as a sole proprietorship, such as self-employment taxes.
Advantages and Disadvantages of Being Taxed Like a Partnership
In the owner of an LLC elects to be treated like a partnership for tax purposes, the owner will also not be subject to double taxation. Instead, as stated above, the partnership falls into the “pass through” category and the owner does not need to pay taxes on the partnership twice. He or she will just report the partnership’s income on his or her personal tax returns.
Owners are also able to deduct business expenses from the total income of the partnership. Eligible business expenses include costs of starting your partnership, maintenance costs, and business-related travel.
A partnership will still have to pay self-employment taxes on all of the partnership’s profits that were distributed to the owners. This includes making payments to the social security and medicare funds.
If you need help deciding how your LLC should be classified for tax purposes, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.