Limited Liability Companies (LLCs) have become a popular choice for entrepreneurs and small business owners due to their flexibility and liability protection. One of the key advantages of forming an LLC is the flexibility it offers regarding taxation.
Unlike businesses legally structured as corporations (Inc’s) and partnerships (GP’s or LP’s), LLCs don’t necessarily have their own income tax returns. Instead, the IRS gives LLCs a default tax treatment based on the way that they are owned under state law.
By default, LLCs are pass-through entities, which means that the business’s profits and losses are reported on the owners’ personal tax returns. However, LLCs also have the option to change this default treatment through a tax election (aka the “check-the-box election”). No matter what election you make for tax purposes you will still legally be an LLC and no tax election would change that.
Default Taxation for LLCs
Single-Member LLCs: When a single individual forms an LLC, it is automatically treated as a disregarded entity for federal tax purposes. This means that the IRS does not recognize the LLC as a separate entity, and all income and expenses of the LLC are reported on the owner’s personal tax return. Essentially, the single-member LLC is taxed as a sole proprietorship.
If a tax reporting business (such as a partnership) owns 100% of an LLC, the same treatment is applied. In other words, the LLC is treated as if it doesn’t exist and its activities get reported at the parent company level.
Multi-Member LLCs: When more than one individual forms an LLC, they are automatically treated as a partnership for federal tax purposes. Like single-member LLCs, the LLC itself does not pay federal income tax. Instead, the profits and losses of the business “pass through” to the individual members, who report this income on their personal tax returns. The key difference here is that a partnership tax return is required to be filed which increases tax compliance and the complexity of your tax situation. This is true even if a married couple form an LLC in most states. However, if you live in one of the few community property states then an LLC owned by married spouses is given disregarded treatment and will be treated as a sole proprietorship. There are other exceptions to the married spouse owned LLC treatment as a partnership as well, but they are more limited in scope. Talk to your tax advisor for further advice.
Changing the Default Tax Treatment for LLCs
LLCs have the option to change their default tax treatment by making what is known as a “check-the-box” election. This election allows the LLC to choose how it wants to be taxed for federal income tax purposes.
Single-Member LLCs or Multi-Member LLCs: No matter how the LLC is owned, it can elect to be taxed as a C Corporation or an S Corporation. The key distinction between these two Corporations is that a C Corporation pays its own income tax (currently a flat tax rate of 21%) and an S Corporation does not pay its own income tax, rather S Corporation tax profits flows through to the owners where it is subjected to income taxes. Deciding between these two types of entites, or whether to make an election in the first place, is a complicated decision that should require all of your advisors buy-ins (attorney, CPA, insurance agent, financial advisor, etc).
S Corporation Election
An S Corporation election is a deemed “check-the-box” election to be treated as a C Corporation followed by a simultaneous election to be taxed as an S Corporation, all accomplished by filing one form – Form 2553.
However, it does not make sense for every business to be an S Corporation, despite their popularity (see 5 Things Every S Corporation Owner Should Know). I often see small businesses who are actually in a worse tax position by being an S Corporation due to previous advisors being too loose with making the election and not considering all the complex tax rules and the goals of the company.
Similar to default LLC taxation, S Corporations are pass-through entities. However, they have an advantage when it comes to self-employment taxes. S Corp owners can split their income into two parts: a reasonable salary (subject to payroll taxes) and distributions (not subject to payroll taxes). This can result in potential tax savings. There are other pros and cons to being an LLC taxed as an S Corp that are out of the scope of this article.
Understanding the default taxation of LLCs and the available elections is crucial for LLC owners to make informed decisions about their overall tax strategy. Each option has its advantages and disadvantages, so it’s essential to consult with a tax professional or accountant to determine the best tax strategy for your specific business needs. Whether you choose to stick with the default taxation or opt for a different tax status, an informed decision can lead to potential tax savings and better financial management for your LLC.