The limited liability company (LLC) can be taxed in several different ways to save on taxes for the business and its owner.Here's how an LLC is usually taxed, how being taxed as a corporation or S corporation can benefit your business, and how to elect this tax option.
Key Takeaways
- LLC profits are typically passed through to members' personal tax returns, but members can also choose to pay corporate taxes instead.
- When an LLC is structured as an S corp or C corp, business profits won't affect the personal income of each member.
- This strategy of taxation can create double taxation because profits are taxed at the corporate level, and when they are passed to shareholders through dividends, those shareholders must pay taxes on that income.
How LLCs Are Taxed
While they can be taxed at the corporate level, LLC profits are typically passed through to each member as self-employment income. For example, if an LLC has three members with equal ownership, and the LLC earns $150,000 in annual profit, each member would receive $50,000 in income that's taxable on their personal returns.
This income is taxed at each member's tax bracket rate according to their total income from the year. Since the LLC income is considered self-employment income, each member will pay the entire FICA tax themselves (employers typically pay half of FICA taxes).
LLC Tax Classifications
The LLC can be considered a disregarded entity, similar to how sole proprietorships are treated, or they can be taxed like partnerships when there are multiple members. Those are the most common classification for LLCs, and in each case, the profits will ultimately be taxed as part of each member's personal income.
LLCs can also be considered corporations. In that case, the entity would pay corporate taxes, rather than passing profits through to members' personal income tax returns.
What It Means When Your LLC Is Taxed as an S Corporation
An S corporation is a special kind of corporation that has some tax advantages. Owners can split their income from the S corporation between a distribution (in the same way as a partner in a partnership) and status as an employee. An S corporation owner who works in the business must be paid a reasonable salary as an employee and must pay tax and FICA tax on this salary.
Because the S corporation profits are distributed to owners, this tax status avoids the double taxation situation.
To qualify to be taxed as an S corporation, the business must meet specific requirements:
- the business can have no more than 100 shareholders
- no shareholder can be a nonresident alien (noncitizen who doesn't live in the U.S.
- there can be only one class of stock
- all shareholders must be individuals (not other businesses)
Another advantage of S corporation status is that an S corp owner can take a 20% tax deduction from their share of business income, in addition to usual deductions for business expenses. This Qualified Business Income (QBI) deduction is calculated on the owner's income as an employee. This deduction is not available for personal service businesses like accounting, law, consulting, or financial services. Also, the QBI deduction is limited or not available for higher-income business owners.
Many LLCs choose the S corporation for its tax status because:
- It avoids the double taxation situation of corporations
- S corporation owners can take the QBI deduction on business income (not employment income)
- Owners pay Social Security/Medicare tax only on employment income.
What It Means When Your LLC Is Taxed as a Corporation
Many LLCs choose to be taxed as corporations to save on taxes. In this tax situation, the LLC members become shareholders and they are not self-employed.
For higher-income individuals or those with profitable LLCs, the fact that corporate shareholders don't have to pay tax on their share of income from the corporation is a tax advantage. The corporate rate (a flat 21%) may be lower than the owners' personal tax rates.
You also avoid having to pay self-employment tax, unless you work in the corporation as an employee (and pay FICA tax).
An Example Scenario
Your LLC has a net profit of $50,000 for the year. If you are the only owner of the LLC, you must take all of this profit on your personal income tax return. If you have the LLC taxed as a corporation, the corporation pays tax on this income, but you as a shareholder only pay tax if you receive dividends.
Pros and Cons of Your LLC Taxed as a Corporation
Pros
Profits don't affect personal tax returns
Avoids self-employment tax
Cons
Double taxation
The main advantage of having an LLC taxed as a corporation is that the owner doesn't have to take all of the business income on their personal tax return. They also don't have to pay self-employment tax on their income as an owner of the corporation.
The main disadvantage is double taxation. The corporation must pay tax on its net earnings, and the owner must pay tax on any dividends they receive.
Making an Election for Your LLC
If you decide to make this election, here is some more information you need to know:
To be taxed as a Corporation, use IRS Form 8832 — Entity Classification Election. The election to be taxed as thenew entitywill be in effect on the date entered on line 8 of Form 8832. The election cannot take effect more than 75 days before the date the election is filed, nor can it take effect later than 12 months after the date the election is filed.
The form includes a consent statement which may be signed by all members, or by one member on behalf of all members. If one member signs, there should be somerecord in company membership meetings that all members approved this election.
You must provide the name(s) and identifying the number(s) of owners (Social Security Number for a single-member LLC, and Employer ID Number for multiple-member LLCs).
To be taxed as an S Corporation, use IRS Form 2553 - Election by a Small Business Corporation. To begin the new tax classification for a year, you must file by March 15, effective for the entire year. You will need to include information about each shareholder: name and address, shares owned, Social Security number, the date the owner's tax year ends, and a consent statement.
For a change to a corporation, when your election to corporate status becomes effective, the IRS determines that all the assets and liabilities of the previous business (sole proprietorship or partnership) are contributed to the corporation in exchange for shares of the corporate stock.
Frequently Asked Questions (FAQs)
What is the best tax classification for an LLC?
The best tax classification for an LLC depends on whether you want your business profits to be taxed at your personal income tax rate, or at the corporate tax rate. If you'd prefer personal tax rates, you can classify it as a disregarded entity or as a partnership. Otherwise, you can classify it as a corporation.
How can an LLC be taxed as an S Corporation?
To choose to tax your LLC as an S corporation, you'll need to file IRS Form 2553 by March 15 of the year in which you intend to file taxes as an S corporation. You'll need to include each shareholder's name, address, Social Security number, and more.
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