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Tax Classifications for LLC: Everything You Need to Know

Since the Limited Liability Company is a relatively new form of business entity, the tax classifications for LLC are the same as existing businesses. This means that the owners of an LLC can choose to structure their business in a different way for tax purposes.

The way you structure your business has legal and tax consequences. While sole proprietorship, partnership and corporation are recognized by the Internal Revenue Code (IRC) and state code as established business structures, certain states have also authorized the limited liability company as an alternative way to run a business. Since the IRC has made no provision for taxing LLC, the company can choose to be taxed as one of the recognized business structures.

What this article covers:

What is the Default Tax Classification of an LLC?

By default, a single member LLC is taxed as a sole proprietorship while multiple owner companies are taxed as a partnership or a corporation.

Based on the ownership structure and the type, the LLC pays income tax differently. The owner of an LLC is referred to as a member. If an LLC has one member, it’s known as single-member LLC. Apart from individual members, the LLC can be owned by a corporation, an S-Corporation, a trust and another LLC.

LLCs are classified as “pass-through” entities for tax reasons, meaning the business profits and losses will flow through to the personal tax return of each member.

An LLC can also elect to be taxed as an S-Corporation or a C-Corporation. To be taxed as an S-Corporation, the LLC must file IRS form 2553, check the LLC box and write “S” in the blank space next to LLC. To be taxed as C-Corporation, the LLC must complete IRS form 8832, check the LLC box and write “C” in the blank space next to LLC.

What Taxes Does an LLC Pay?

The taxes that an LLC pays depends on the corporate structure of the LLC.

Sole Proprietorship

If the LLC is structured as a sole proprietorship for taxation, it’s treated as a disregarded entity by the IRS. A disregarded entity is a type of business that exists separately for the business and its owner for liability and legal purpose, but not for taxation.

This means that the taxes that are incurred by the LLC are passed on to the owner’s personal tax requirements. This means that the LLC is taxed however its owner is taxed. The LLC activities are reported by the owner on either a Schedule C, Schedule E or a Schedule F of their personal tax return.

Partnership

If the LLC has more than one member, by default, it’s taxed as a partnership. Similar to taxation as a sole proprietorship, the taxes incurred by a multi-member LLC would also pass directly through to those partners in the business. This means all owners would handle their business-related taxes on their personal returns and taxed on the LLC’s profits and losses.

An information return is filed by the members on Form 1065 indicating the total profits and losses from the partnership. In addition, the members receive a Schedule K-1 tax form to report their portions of the profit or loss. This form is included with the member’s personal tax return.

S Corporation

For tax purposes, businesses can choose to be classified as corporations. If the members have elected to structure an LLC to be taxed as an S Corporation, all taxes resulting from business activities are passed through to the personal tax obligations of an LLC’s owners.

The corporation does not have to pay federal taxes on profits. This means that the S corporation owners can report the profits and losses of the LLC on their personal tax returns and not incur double taxation. The tax returns are filed on Form 1120-S and the owners file a Schedule K-1.

C-Corporation

While it’s complex to structure your LLC as a C-Corporation, it can have some advantages. When the LLC is taxed as a C-Corporation, it means that the LLC is taxed directly as a separate business entity. Unlike taxation as a partnership or sole proprietorship, the taxes incurred by the business are not passed through to the owner’s personal taxes.

This structure separates the owner’s personal and business assets and also allows businesses to take advantage of deductions.

However, the biggest disadvantage of an LLC taxed as a C-Corporation is double taxation. Unlike a pass-through entity, an LLC with C-Corp tax classification is taxed at the corporate and the personal level. The LLC must file an income tax return with the IRS for the business while the owners must also file personal income taxes.

The owners of the LLC must make the appropriate decision for the tax classification of the LLC based on the tax benefits and savings that the business may be able to enjoy. While filing changes for LLC tax status to a C- or an S-corporation, the owners must consult a tax professional for assistance and advice.

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