How to Select a Tax Classification of your LLC

Calculation of Taxes: example

Commendable about LLCs is the fact that you have a chance to decide which taxation form to choose in relation to your LLC. You can read on to find out every detail of your different tax options so that you can select the best tax choice.

Tax Classification of LLCs as default

The default position of LLCs is that of a pass-through, that is, the income is transferred to the member or members. The automatic taxation of the LLC is a sole proprietorship in case of a lone member. In case the LLC consists of more than one member, it automatically becomes partnership taxed.

However, as stated above, LLCs are peculiar in the sense that they have the option of being taxed like a corporation in case the members find it economical. It is done by submitting an election form to the IRS. You have a choice of either being taxed as a C-Corporation or S-Corporation.

C-Corp status implies the taxation of income at the prevailing federal corporate tax rate that may be lower than the rates of individual taxpayers. Note though that shareholders of C-Corps, which is the case with LLC, also have to pay tax on their distributions. This is referred to as double taxation.

Nevertheless, in an LLC where the tax is defaulted against as a sole proprietorship or partnership, members are liable to self-employment tax. Distributions no longer incur the self-employment taxes when such an LLC changes to the taxation as a corporation.

Equally, reasonable distributions made to members with S-Corp status are not subject to self-employment taxes and that is the key benefit of S-Corp status election. The S-Corp status will also imply that your LLC will remain a pass through entity and not subject to corporate taxes.

S-Corp Tax Status Knowledge

The IRS permits the S-Corp status provided that your business is fulfilling some requirements. To convert your LLC into an S-Corporation; it must:

• Be domestic corporation or limited liability.
• Are only permissible shareholders (individuals, specific trusts, and estate, but not partnerships, corporations or non-resident alien shareholders)
• Not more than 100 shareholders.
• Have only one class of stock
• Not an ineligible corporation (i.e. some financial institutions, insurance companies and domestic and international sales corporations)

Under S-Corp, members will typically be treated as employees of the company, and so there will be increased accounting and payroll costs. Consequently, the S-Corp is not advantageous in cases when the self-employment tax savings are higher than those extra costs.

Your tax consultant can assist you to work out the revenue level that S-Corp status is financially viable to your business. In order to elect S-Corp status, you have to submit Form 2553 to the IRS, which you usually do within 75 days of organizing your LLC or otherwise by March 15 of the year that you wish the election to take effect.

Learning the C-Corp Tax Status

There is a need to be careful and calculate if the C-Corp is financially advantageous to your LLC. You would be interested in knowing all the taxes you would pay as a C-Corp in contrast to the self-employment taxes and the default taxation of your LLC. On top of this, there are the incremental costs of operation of a C-Corp, such as formal board meetings, comprehensive documentation, and paying of employees.

The taxes that you will pay as a C-Corp will be corporate taxes on the company profits, income taxes on your salary as an employee, payroll taxes (employer and employee) and taxes on the dividends paid to shareholders. But your salary is not going to be subject to self-employment taxes.

C-Corp status is unlikely to pay less money to the small businesses in most cases because of the double taxation. Rather, the primary reason why LLC owners prefer C-Corp status lacks is to attract investors to their business more, as it is easier to transfer ownership of a C-Corp share, as opposed to transferring a percentage of LLC membership. C-Corp is also advantageous where the company is planning to go public or raise a lot of venture capital.

The other benefit of electing the C-Corp status and classification as an employee is that you can offer yourself a tax-advantaged benefit in the form of health insurance, life insurance and retirement plan. C-Corp status is elected using the form 8832 (Entity Classification Election) which is filed with the IRS.

The Comparison of the Tax Classifications

Pass-Through taxation (Default)

Under default LLC tax, you transfer all the income of the business to your individual returns. It will collect income tax at your personal rate in addition to self employment tax (15.3 per cent on your net income to the social security wage base). It is the least complicated with minimum paperwork and does not involve separate tax filing of the company.

S-Corporation Election

S-Corp status enables you to divide income based on the payroll taxes issued as salary and distributions based on no self-employment tax. This may save a lot of taxes, although it involves the operation of payroll, paying yourself a fair salary and filing a separate company tax return (Form 1120-S).

C-Corporation Election

C-Corporation status implies that your business will pay corporate income tax on the profits of the business as well as personal income tax on the salary and any dividends that you receive. Although this amounts to a double taxation, it may be good in terms of retention of earnings in the company, provision of benefits to the employees or even in preparation of outside investment.

The way to change the tax classification of LLC

The process of changing your tax classification is an easy one though you must take your time. In order to choose to have S-Corp status, send Form 2553 to the IRS. For C-Corp status, file Form 8832. This is normally effective on the opening day of the tax year hence one must plan in advance.

It is worth remembering that after a tax election has already been made, then you are limited to making another tax election. In most cases, you are not allowed to change the classification of your tax in 60 months of inception (5 years) of initial election without IRS approval.

You should consult a qualified tax professional or CPA before assuming that there is a specific financial situation, projected income, or business goals that you plan to reach before making any election. A proper tax classification is going to save you thousands of dollars a year, but a wrong classification is going to cause avoidable complications as well as costs.

Frequently Asked Questions