Tax classification for LLC: 4 options for small business
A limited liability company (LLC) is one of the most common types of legal business entities. Even if something goes wrong with your business, your personal assets will remain safe from potential liabilities.
The key benefit of an LLC is the opportunity to choose how you want to be taxed. LLCs do not have their own tax classification; available taxation options depend on how your LLC is structured.
In this article, we will cover four different tax classifications of an LLC so that you can choose the right one for your business.
What is the tax classification of an LLC?
An LLC can choose to be taxed as a sole proprietorship, partnership, corporation, or S corporation.
When you form an LLC, the Internal Revenue Service (IRS) automatically categorizes it as a sole proprietorship or partnership for tax purposes. The number of members determines the classification.
The IRS also allows you to change your LLC default tax classification and file your business taxes as a corporation or an S corporation.
You also have the option to revert to default statuses and file as a sole proprietorship or partnership. However, this can only be done five years after the effective date of electing the corporation tax classification.
The tax classification can drastically change your taxable income at the end of the year. For example, if you have a single-member LLC and your taxable income is $80,000, choosing an S corporation tax classification might be beneficial. It will allow you to save money on social security and Medicare taxes. Changing your business tax classification might result in paying 15-20% less in taxes.
Talk to TFX tax professionals to select the optimal entity type for taxes and lower your tax bill when setting up or restructuring your business.
Sole proprietorship
By default, single-member LLCs are disregarded entities for tax purposes. This means that there is no distinction between the business and its owner.
A single-member LLC does not require the preparation of a separate tax return for its business. The business income transfers over to your personal return. Plus, you will need to pay a self-employment tax – 15.3%.
The fundamental difference between a single-member LLC and a sole proprietorship is that the former allows you to separate yourself as an individual taxpayer from your business entity. This is especially important if you have a business with high risk or personal assets like property you want to protect.
How to file: Schedule C, part of Form 1040, reporting income and expenses.
Due date: April 15.
Partnership
When your LLC has two or more owners, it is taxed as a partnership.
Since the LLC does not pay taxes, the net income and losses are divided equally among all the partners. Each partner is responsible for paying taxes on their share of the business income at their personal tax rate.
Multi-member LLCs with partnership tax classification have two advantages. First, it is a separate legal entity. Second, it benefits from pass-through taxation.
How to file:
- Form 1065, US Return of Partnership Income
- Schedule K-1 (1065), the share of income, deductions, and credits
Due date: March 15.
Also read. Complete guide to multi-member LLC taxation
S corporation
An S corporation is not an entity type but a tax classification. You can not form an S corporation, but you can select your business to be taxed as such. The owner or owners of an LLC can choose this tax classification by filing Form 2553.
When an LLC chooses an S corporation tax classification, the owner or owners can pay themselves through salaries and distributions. They only have to pay taxes on the money they make from the business. This helps avoid double taxation, a common issue with C corporations.
Using an S corporation for taxes is more complicated than using a partnership or sole proprietorship. It requires additional effort to file taxes and keep records. An S corporation also has some limitations on reinvesting money back into the business.
How to file:
- Form 1120-S, US Income Tax Return for an S Corporation
- Schedule K-1 (Form 1120-S), share of corporate income, credits, and deductions
Due date: March 15.
You must pay yourself a reasonable salary as an “employer” and an “employee” in your S corporation. The IRS taxes salaries differently than distributions: The salary is subject to employment tax and income tax, while the distributions are only subject to income tax. This is where you can potentially have significant tax savings if you are an S corporation.
C corporation
As an owner of an LLC, you can elect corporation tax status by using Form 8832.
A C corporation is not a flow-through entity; it pays its own income tax, which is currently a flat 21%.
When you file as a corporation, your business loses the advantages of being a pass-through entity. You must pay taxes for your company and the money you receive from the company as dividends. This is why corporation status is a less preferred tax classification among small business owners.
How to file: Form 1120, U.S. Corporation Income Tax Return.
Due date: April 15.
Also read. How to change an LLC to a C corp
What is the best tax classification for an LLC?
The best tax classification for an LLC depends on your priorities, income, and business strategy. There is no one-size-fits-all answer.
If you earn enough profit to pay yourself a reasonable salary, consider converting to an S corporation. This could lower your taxes.
The IRS does not have a definition of a “reasonable salary,” but it should not be too low. An unreasonably low salary could raise a red flag for avoiding self-employment tax and lead to a tax audit.
If you have plans on reinvesting all or most of the business profits back into the business, a C corporation might be a good option for you.
Suppose you are just starting your business with too many uncertainties regarding income, growth strategy, and operations. In that case, sticking with the default LLC tax classification might be your best option.
Consult with TFX tax professionals to determine which tax classification will suit your small business and whether the benefits of entity restructuring outweigh the cost.
FAQ
Unless you elect your LLC to be treated as a corporation or an S corporation, its tax classification is either as a sole proprietorship or a partnership.
The default tax classification for a single-member LLC is a disregarded entity, while the default tax classification for a multi-member LLC is a partnership.
By default, an LLC is a pass-through entity that does not pay taxes. Instead, it passes its income directly to its owners or partners. The LLC's election to be taxed as an S corp also means it is a pass-through entity. If you choose a C corporation for your LLC, it will no longer be a pass-through entity. Instead, it will have to pay its own taxes.
The deadline for LLC tax returns depends on whether you are a sole proprietorship, partnership, an S corporation, or a C corporation for tax purposes.
Your LLC tax classification defines whether you need to file your business and personal tax return together. If you have a single-member LLC, you must file your business taxes on Schedule C (Form 1040) together with your personal taxes. You must always file a separate return if your LLC has any other tax classification: corporation, S corporation, or partnership.
Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.