How to understand LLC Tax Classification

Rather, the IRS lets the owners of LLCs decide on the type of taxation that their business would be given, based on the size of the number of members and financial objectives. Selecting an appropriate tax classification may greatly influence your level of payment of taxes to be paid, the manner in which profits are disbursed, and the extent to which your accounting and payroll needs are complicated. It is a comprehensive guide to the all options of LLC classification to be taxed so that you can decide.

The Taxation of LLCs by the IRS

LLC is not a taxation type but a legal form. Unless the LLC opts to choose otherwise through the submission of the right forms, the IRS taxes such LLC under default rules.

The LLCs are by default either one of the following:

• Single-member LLC
• Multi-member LLC

Nevertheless, LLCs also have the opportunity to be taxed as C Corporation or S Corporation, which makes four principal tax classification forms to be considered by business owners.

1. Single-Member LLC: Disregarded Entity

SMLLC is automatically described by the IRS as a disregarded entity, with the exception of the owner opting otherwise.

How It's Taxed

• The LLC is not subject to paying federal income tax
• All the income and expenses are towards the personal tax return of the owner which is normally in schedule C
• Profits are liable to income tax and self- employment tax

Pros

• Simple tax filing
• Minimal paperwork
• No filing of business tax returns

Cons

• The self-employment tax is paid on all net profits of the owner
• Less opportunity of tax-saving at high income

This is the best alternative among small businesses, freelancers, and consultants whose profits are not so high and they desire simplicity.

2. Multi-Member LLC: Taxation of Partnership

A multi-member LLC is defaulted to be taxed as a partnership.

How It's Taxed

• The LLC has an informational filing (Form 1065)
• Every member is given a Schedule K-1, which indicates his or her portion of profits or losses
• The share is reported by the members on their individual tax returns
• Self employment tax applies to profits

Pros

• Pass-through taxation (no entity level tax)
• Variable profit and loss apportionments
• The ownership interests of members are segregated

Cons

• Tax filing more complicated than that of a single-member LLC
• Self-employment tax is subjected to active members

It is a good classification that suits LLCs that have several active owners and wish to be flexible but not corporate.

3. LLC Taxed as a C Corporation

The LLC has the option of becoming a C Corporation by submitting IRS Form 8832.

How It's Taxed

• The LLC pays a corporate income tax (21% federal rate)
• Members are taxed a second time on dividend or distributions
• This causes duplication of taxation

Pros

• Reduced corporate tax rate against high individual tax rates
• Power to save profits in the business
• Appealing to the venture capital investors

Cons

• Double taxation on profits
• Increased compliance, accounting, and reporting
• Dividends are non-tax deductible

This alternative can be of interest to LLCs intending to reinvest, grow at a fast pace or require external funding.

4. LLC Taxed as an S Corporation

Form 2553 (and occasionally Form 8832) is also used to the LLC electing S Corporation tax status.

How It's Taxed

• Pass-through (no corporate income tax) taxation
• The owners working in the business are to be paid a decent salary
• Payroll taxes are applied to salary
• Profits remaining are paid out in dividends, and do not qualify as self-employment tax

Pros

• Self-employment taxes that could be saved
• Pass-through taxation eliminates the double taxation
• Famous with lucrative small businesses

Cons

• The complexity of payroll and accounting
• IRS examination of reasonable salary
• Restriction of number and category of shareholders

The taxation of S Corp can be quite advantageous when the LLC gains a sufficient amount of profits to cover payroll and administration expenses.

Selecting the LLC Tax Classification

One size cannot fit it all. The optimal tax typology is reliant on:

• Number of members
• Annual profits
• Long-term growth plans
• Administrative budget
• Active working of members in the business or not

Most LLCs begin with default taxation and change to S Corp or C Corp with increase in profits.

Switching the Tax Classification of Your LLC

The LLCs may reclassify to tax classes, however, timing and IRS regulations are important:

• Elections are usually either current or succeeding tax year
• Limitations can be imposed in case of too frequent changes in classifications
• The recommendation of professional guidance is high

Final Thoughts

The most significant strength of this business structure is the flexibility of its LLC tax classification. Regardless of deciding on default pass-through taxation or electing corporate status, the correct decision can lower taxes, ease compliance, and with the help of long-term growth.

Knowing what you have to do and revisiting this with the changes in your business makes your LLC not only legal, but also economically effective. Professional advice may enable you select the right path that best suits your business objectives, when being in doubt.

Frequently Asked Questions