How to Choose a Tax Classification for Your LLC

LLCs are unique because you can choose how you want your LLC to be taxed. Read on to learn all about your various tax options so that you can choose the best one for you.

Default Tax Classification for LLCs

By default, LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it's taxed as a sole proprietorship by default. If the LLC has more than one member, it's automatically taxed as a partnership.

Yet as mentioned above, LLCs are unique in that they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. You can choose to be taxed as a C-Corporation or an S-Corporation.

C-Corp status means income is taxed at the current federal corporate rate, which can be lower than individual taxpayer rates. But keep in mind that C-Corp shareholders—who are members in the case of an LLC—must also pay taxes on their distributions. This is called double taxation.

However, members are subject to self-employment tax in an LLC that is taxed by default as a sole proprietorship or partnership. Once such an LLC switches to being taxed as a corporation, self-employment taxes no longer apply to distributions.

Similarly, self-employment taxes do not apply to reasonable distributions for members with S-Corp status, which is the main advantage of electing S-Corp status. S-Corp status also means that your LLC will still be a pass-through entity and not subject to corporate taxes.

Understanding S-Corp Tax Status

The IRS allows S-Corp status if your business meets certain conditions. For your LLC to become an S-Corporation, it must:

• Be a domestic corporation or LLC
• Have only allowable shareholders (individuals, certain trusts, and estates—not partnerships, corporations, or non-resident alien shareholders)
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic and international sales corporations)

With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings are more significant than those additional expenses.

Your tax advisor can help you calculate the revenue level at which S-Corp status makes financial sense for your business. To elect S-Corp status, you must file Form 2553 with the IRS, typically within 75 days of forming your LLC or by March 15 of the tax year you want the election to take effect.

Understanding C-Corp Tax Status

Determining whether C-Corp status is financially beneficial for your LLC requires careful calculations. You'll want to determine all the taxes you'd pay as a C-Corp compared to your LLC's default taxation, including self-employment taxes. Also, consider the added expenses of running a C-Corp, including formal board meetings, extensive record-keeping, and paying employees.

The taxes you'll pay as a C-Corp will include corporate taxes on company profits, income taxes from your salary as an employee, payroll taxes (both employer and employee portions), and taxes on dividends distributed to shareholders. You will not, however, pay self-employment taxes on your salary.

In most cases, C-Corp status is unlikely to save small businesses money due to double taxation. Instead, the main reason that LLC owners choose C-Corp status is to make their business more attractive to investors, since transferring ownership of C-Corp shares is easier than transferring a percentage of LLC membership. C-Corp status is also beneficial for companies planning to go public or raise significant venture capital.

Another advantage of electing C-Corp status and being classified as an employee means that you can provide yourself tax-advantaged benefits such as health insurance, life insurance, and retirement plans. To elect C-Corp status, you'll file Form 8832 (Entity Classification Election) with the IRS.

Comparing Tax Classifications

Pass-Through Taxation (Default)

With default LLC taxation, all business income passes through to your personal tax return. You'll pay income tax at your personal rate plus self-employment tax (15.3% on net earnings up to the Social Security wage base). This is the simplest option with minimal paperwork and no separate corporate tax return required.

S-Corporation Election

S-Corp status allows you to split income between salary (subject to payroll taxes) and distributions (not subject to self-employment tax). This can result in significant tax savings, but requires running payroll, paying yourself a reasonable salary, and filing a separate corporate tax return (Form 1120-S).

C-Corporation Election

C-Corp status means your business pays corporate income tax on profits, and you pay personal income tax on your salary and any dividends received. While this creates double taxation, it can be beneficial for retaining earnings in the company, offering employee benefits, or preparing for outside investment.

How to Change Your LLC's Tax Classification

Changing your tax classification is a straightforward process but requires careful timing. To elect S-Corp status, file Form 2553 with the IRS. For C-Corp status, file Form 8832. These elections typically take effect on the first day of the tax year, so planning ahead is essential.

It's important to note that once you make a tax election, there are restrictions on changing it again. Generally, you cannot change your tax classification for 60 months (5 years) after the initial election, unless you have IRS approval.

Before making any election, consult with a qualified tax professional or CPA who can analyze your specific financial situation, projected income, and business goals. The right tax classification can save you thousands of dollars annually, but the wrong choice can create unnecessary complications and expenses.

Frequently Asked Questions