Tax Classification for LLC: The Complete Guide for 2023 [+ IRS Tips]

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You heard that an LLC was the best legal structure for your new business. But how much do you know about LLCs? In addition, what is the tax classification for an LLC?

Even though the IRS has default LLC tax classifications, they can typically be changed to elect a different tax status. So, fortunately, if you don’t like the default classification, you can select another one.

This article will discuss LLC taxes and how they will be taxed in the eyes of the IRS. We will cover the default classifications but also address some of your other options. I will even touch on how these options are classified so you can make an intelligent decision. Let’s get started.

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What is an LLC?

A limited liability company (“LLC”) is a popular legal business structure that combines elements of a corporation and a partnership. It provides business owners with limited liability protection while offering flexibility in management and taxation. An LLC is created by filing the necessary formation documents with the appropriate state agency, typically the Secretary of State. Once formed, an LLC is considered a completely separate legal entity from its owners (also called members).

One of the critical advantages of an LLC is limited liability protection. This means that the member’s personal assets are typically protected from the debts and liabilities of the business. If the LLC faces legal action or financial obligations, the member’s personal assets, such as homes or bank accounts, are not typically at risk. However, it’s imperative to note that there are situations where limited liability protection can be pierced, such as the commingling of personal and business funds or fraudulent activities.

Another notable feature of an LLC is its flexibility in terms of management and taxation. Unlike a corporation with a more rigid structure with shareholders, directors, and officers, an LLC can be managed by its members or the designated managers. This allows for greater flexibility in decision-making and day-to-day operations.

In summary, an LLC is a legal entity structure that offers its member’s limited liability protection while providing flexibility in management and taxation. It combines the benefits of a corporation, such as limited liability, with the flexibility of a partnership. An LLC is formed by filing the necessary documents with the state and is considered a separate legal entity from its owners. With its advantageous features, an LLC has become popular for many small and medium-sized businesses.

Pass-through taxation

One of the most significant tax benefits of an LLC is pass-through taxation. This means the business does not pay taxes on its profits or losses. Instead, the profits and losses are “passed through” to the individual members, who report them on their personal tax returns. This avoids the double taxation that corporations face, where profits are taxed at both the corporate and individual levels.

Pass-through taxation is particularly beneficial for small businesses and startups with little profits in the early years. By offsetting losses against personal income, members can reduce their overall tax liability.

Additionally, an LLC can choose its tax classification. An LLC is treated as a pass-through business entity for tax purposes by default. This means that the profits and losses of the company pass through to the members’ individual tax returns. But the good news is that an LLC may elect to be taxed as a corporation if it benefits the company.

LLC taxation myths

People are often confused regarding LLC taxation. A common belief is that just establishing an LLC somehow gives you tax benefits. In fact, there is no distinction in the IRS tax code for an LLC itself.

When LLCs were established in the 1980s, the IRS did not know how to tax them. Were they corporations or just some or just some alternative Business structure?

At the end of the day, the IRS decided to establish default LLC classification rules and then created checkbox rules (more about this later). Thankfully, these rules clarified many tax issues and enabled LLCs to become the most flexible tax structure. In essence, you can decide how it is taxed.

What is the initial Tax Classification for an LLC?

By default, a newly formed LLC in the United States is classified as a disregarded entity if it has only one member or as a partnership if it has more than one member. This means that the LLC’s income and expenses are reported on the owner’s or owners’ personal tax returns.

However, LLCs have the option to elect to be taxed as a corporation by filing Form 8832 with the IRS. If the LLC chooses to be taxed as a corporation, it can elect to be taxed as either a C corporation or an S corporation. The election must be made within 75 days of the LLC’s formation or during the current tax year to be effective for that year.

Scrabble pieces spelling TAX

Another significant tax concern of an LLC is self-employment. Members of an LLC who are actively involved in the business are considered self-employed for tax purposes. This means they are subject to self-employment tax, including Social Security and Medicare taxes.

What are the LLC check the box rules?

If you don’t like the initial tax classification of your LLC, you are in luck. You can change it.

The LLC “check the box” rules are a set of regulations issued by the IRS that allow limited liability companies (LLCs) to select how they want to be taxed. Under these rules, LLCs are classified as either disregarded entities, partnerships, S corporations, or C corporations for tax purposes.

The “check the box” rules are so named because the LLC chooses its tax classification by checking a box on IRS Form 8832, Entity Classification Election. This form allows the LLC to decide whether to be taxed as a sole proprietorship, partnership, C corporation, or S corporation.

Here is a quick overview of how the “check the box” rules work for each tax classification:

  • Disregarded entity: If the LLC has only one owner, it will be treated by default as a disregarded entity for federal tax purposes. This means that the LLC’s income and expenses are reported on the owner’s tax return on Schedule C.
  • Partnership: When the LLC has more than one owner, it is treated as a partnership for federal tax purposes, which means that the LLC’s income and expenses are reported Form 1065 and net profit or loss will be included on the partners’ personal tax returns.
  • S corporation: An LLC can elect to be treated as an S corporation for income tax purposes, which means the LLC’s income and expenses are passed through to the shareholders’ personal tax returns, and the LLC itself is not subject to federal income tax.
  • C corporation: An LLC can elect to be treated as a C corporation for tax purposes, which means that the LLC is taxed separately from its owners, and the owners are not personally liable for the LLC’s tax liabilities.

It’s important to note that each tax classification has advantages and disadvantages. The best option for a specific LLC will depend on its unique circumstances, size, business structure, and goals. It’s recommended that business owners consult with a tax professional to determine the best tax classification for their LLC.

S-Corporation tax classification

If you’re a business owner, particularly of a small or medium-sized business, you may have heard of the term “S corporation,” or S corp for short. One of the primary benefits of forming an S corp is the potential for tax savings, particularly when it comes to self-employment tax. In this guide, we’ll take a closer look at what is S corp self-employment tax, how it is calculated, and how it can benefit business owners.

An S corporation is a specific type of corporation that is taxed like a partnership. This means the company’s profits and losses are passed through to the owners’ personal or individual tax returns. The owners then pay personal tax on their share of the company’s profits.

LLC ProsLLC Cons
Limited liability protectionHigher administration
Flexible tax optionsState renewal fees
Easy set upAll income subject to self-employment tax
Professional appearanceNo Tax-free fringe benefits
tax classification for LLC

They avoid double taxation like a C corporation because the profits will flow through to the individual owners. The S corporation does not pay tax and does not have traditional dividends.

An LLC must first meet specific requirements to elect to be taxed as an S corporation. The LLC must have at most 100 shareholders, all of whom must be individuals, estates, or certain trusts. The LLC must also have only one class of stock and no nonresident alien shareholders.

tax classification for an LLC

If an LLC meets these requirements, it can file Form 2553 with the IRS to elect to be taxed as an S corporation. Once the election is made, the LLC will be treated as an S corporation for tax purposes.

An S corporation is similar to a partnership, which flows through or passes through the profit to the business owners. Business owners are considered shareholders and receive business profits outside of employment taxes. However, they are required average for the services performed by the company. This must meet IRS reasonable population rules.

Suppose an LLC elects to be taxed as an S corporation. In that case, members who work in the business can pay themselves a reasonable salary and only pay self-employment tax on that amount. Any additional profits can be distributed as a dividend, not subject to self-employment tax. This can result in significant tax savings for members of the LLC.

What is the best tax classification for an LLC?

Determining the best LLC tax structure depends on various factors, including the specific circumstances and goals of the business owners. Here are three common tax structures for LLCs:

  1. Default Tax Classification (Pass-through): An LLC with multiple members is classified as a partnership for tax purposes by default. At the same time, a single-member LLC is treated as a disregarded entity (sole proprietorship). In both cases, the LLC’s profits and losses “pass-through” to the members’ or owner’s individual tax returns. This structure can benefit businesses that want to avoid double taxation at the entity level and have more flexibility in allocating profits and losses among members.
  2. S Corporation (S Corp) Election: An LLC can elect to be taxed as an S Corporation for tax purposes, provided it meets specific eligibility requirements. Electing S Corp status allows the LLC to pass through its income and losses to the members while potentially minimizing self-employment taxes. Instead of paying self-employment taxes on the entire net income, only a reasonable salary paid to the owner-employee is subject to self-employment tax. The remaining profits can be distributed to the owners as dividends, which are not subject to self-employment tax.
  3. C Corporation (C Corp) Election: Although less common for LLCs, it is possible for an LLC to elect to be taxed as a C Corporation. This structure may be suitable for LLCs anticipating significant growth and retaining earnings within the company. C Corporations are subject to corporate-level income tax. Still, they offer certain advantages, such as more flexibility in structuring employee benefits and the potential for raising capital through the issuance of stock. However, it’s important to note that C Corporations are subject to double taxation since the entity’s profits and dividends distributed to shareholders are taxed.

The choice of the best LLC tax structure depends on the business’s specific circumstances, long-term goals, and tax implications. 

LLC tax forms

Here are the IRS tax forms commonly used by partnerships, S corporations, and C corporations:

For Partnerships (Form 1065):

  1. Form 1065: U.S. Return of Partnership Income – This form is used by partnerships to report their income, deductions, gains, losses, and other relevant information. The form is used to report the partnership’s income, which is then passed through to the individual partners, who report it on their own tax returns.

For S Corporations (Form 1120S):

  1. Form 1120S: U.S. Income Tax Return for an S Corporation – S corporations file this form to report their income, deductions, gains, losses, and other relevant information. The Form 1120S is used to report the S corporation’s financial information.

For C Corporations (Form 1120):

  1. Form 1120: U.S. Corporation Income Tax Return – C corporations file this form to report their income, deductions, gains, losses, and other relevant information. C corporations are separate tax entities, paying taxes on their income at the corporate level. Form 1120 reports the C corporation’s financial information and calculates its tax liability.

In addition to the above forms, other accompanying schedules, attachments, or informational forms may need to be filed depending on certain circumstances of the partnership, S corporation, or C corporation. 

Steps to determining tax classification

Determining how your Limited Liability Company (LLC) is taxed involves understanding the various options available and making informed decisions. While I can provide you with a general framework, it’s important to consult with a tax professional or an attorney for personalized advice. Here are five steps that can help you navigate the process:

Here are the five steps:

  1. Understand the default tax classification

    By default, an LLC with a single member is treated as a “disregarded entity” for tax purposes, meaning it is taxed as a sole proprietorship. If your LLC has multiple members, the default tax classification is a partnership. It’s important to understand these default classifications before considering other tax options.

  2. Evaluate electing S Corporation status

    LLCs can choose to be taxed as an S Corporation by filing Form 2553 with the Internal Revenue Service (IRS). Electing S Corporation status allows the LLC’s income to pass through to the individual members’ tax returns, similar to a partnership. However, S Corporations have certain eligibility criteria and additional requirements, such as issuing stock and maintaining certain records.

  3. Consider the benefits of partnership taxation

    If you have a multi-member LLC or if you prefer the flexibility and simplicity of partnership taxation, you may choose to be taxed as a partnership. Under this structure, the LLC does not pay federal income tax itself, and instead, the profits and losses are passed through to the individual members’ tax returns. Each member pays taxes on their allocated share of the LLC’s income.

  4. Assess the advantages of C Corporation taxation

    While less common for LLCs, there are cases where electing C Corporation status may be beneficial. C Corporations are separate tax entities, and the corporation itself pays income tax on its profits. If you anticipate retaining earnings within the company or plan to raise capital through the issuance of stock, you might consider this tax classification. However, be aware that C Corporations are subject to double taxation, where both the corporation’s profits and any distributed dividends are taxed.

  5. Research state and local taxes

    In addition to federal taxes, you need to consider state and local taxes. Each state has its own tax laws and regulations regarding LLC taxation. Research the specific tax requirements in the state where your LLC is registered and operating. Some states impose additional taxes or have different rules for LLCs, such as franchise taxes or gross receipts taxes.

Final thoughts

When starting a business, choosing the proper legal structure is a critical decision that can impact your tax liability, liability exposure, and overall operations. One option that has gained popularity among entrepreneurs and small business owners is the Limited Liability Company (LLC).

An LLC is a legal entity that provides the benefits of both a corporation and a partnership while avoiding some of the disadvantages of both. In this article, we’ll examine the LLC tax benefits and why it may be the right choice for your business.

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