LLCs are among the most flexible business structures, especially when it comes to taxation. You can choose from a menu of taxation options, but be careful – picking the wrong one can have expensive consequences.
Default LLC taxation
If you don’t specifically choose otherwise, your LLC will be taxed using a default form based on how many members (meaning owners) the LLC has.
Single-member LLCs
If you are the sole owner of the LLC, then by default your business will be taxed as a “disregarded entity.” This means that instead of filling out a separate tax form for your business, you’ll simply complete Schedule C to list business income and expenses and file it as part of your individual tax return. In other words, it’s the same process as if your business was a sole proprietorship.
Note that if you and your spouse both own the business, and the two of you are the only owners, you can still treat your LLC as a single-member LLC.
Multi-member LLCs
LLCs with more than one owner will normally be taxed like a partnership. This means that you’ll file Form 1065 for the LLC in addition to filing your individual tax return. The business will also be required to create Schedule K-1s for each member. The K-1s break down the business’s profits and losses based on each member’s share of the LLC. Members then use the information on the K-1 to complete their individual tax returns.
Partnerships are a type of “pass-through entity” for tax purposes. That means that the business itself does not pay taxes; rather, all the profits get passed on to the owners and they pay taxes on it as part of their individual income taxes.
Choosing a different taxation approach for your LLC
In some situations members can save a significant amount in taxes by opting to have the LLC taxed as a corporation.
For example, if you choose to leave a significant percentage of the profits in the business rather than distributing that income to the members, corporate taxation could reduce the overall taxes you pay. That’s because if your LLC is being taxed as a partnership, members will be taxed on those profits whether or not they’ve actually received them.
What’s more, since 2018 C corporations have been taxed at a flat 21% – which is significantly lower than the highest individual tax brackets. As a result, the money you leave in the business (formally known as “retained earnings”) will likely be taxed at a lower rate than if you distributed it to the members, but only if you elect to have your LLC taxed as a C Corporation.
Employment factors
If you elect to have your LLC taxed as an S or C corporation, then instead of being self-employed you will be considered an employee of the company. That means that the business will be responsible for calculating and paying your Social Security and Medicare payroll taxes, and it will create a W-2 for you. Managing payroll taxes and other employment issues can be a significant headache, so LLCs without employees should think carefully before electing to be taxed as a corporation.
S Corp or C Corp?
If you do elect to have your LLC taxed as a corporation, you’ll have to decide whether you want to use the S corporation or C corporation taxation model. The differences between the two types of corporations are significant, so it’s important to consult with a CPA or other credentialed tax expert with experience in corporate taxation before you make your choice. For example, S corporations are considered pass-through entities just as partnerships are, while C corporations pay their own taxes at the aforementioned 21% flat rate.
How to change your LLC taxation
Electing a different taxation approach for your LLC is a fairly simple process. You’ll just need to complete Form 8832 and send it to the appropriate IRS office. If you later decide that you want to change your LLC taxation again, you can complete and send in Form 8832 again. However, keep in mind that if you use Form 8832 after the LLC’s initial formation, you’ll need to wait five years from the time of the last election before you can use Form 8832 to make another election. The IRS will make an exception to this waiting period if more than 50% of the ownership of the LLC has switched to new members.
Choosing the right type of LLC taxation
Most LLCs are best off with the default taxation approaches, because these are the simplest options – especially in the case of single-member LLCs. The best LLC taxation strategy for your business will depend on the number of members, the size of the business, how you intend to run the business both now and in the future, the tax brackets of individual members, and more. That’s why it’s important to consult with a tax professional before picking a tax form for your LLC.