LLC Tax Classifications: Which One Should You Choose?

Limited liability companies (LLCs) have a menu of options for taxation. Before choosing S corp or C corp taxation, consider the benefits of sticking with your LLC’s default tax classification.

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The IRS lets limited liability companies (LLCs) choose how they’re taxed. The tremendous tax flexibility granted to LLCs makes it one of the most popular business types.

You can stick to the default tax classification or elect for a new one.

Overview: What is the default LLC tax classification?

The default taxation method for LLC owners depends on the number of owners, called members. Member count aside, all LLCs are automatically taxed as pass-through entities, meaning they pay income tax solely through their members. That’s in contrast to C corporations, which pay a 21% corporate income tax before distributing earnings to shareholders through dividends, who are taxed again at the individual level.

LLCs with one member, called single-member LLCs, are taxed as sole proprietorships. Most small businesses start as sole proprietorships because it requires no registration. One-person businesses often upgrade to LLCs to insulate themselves from business debts and liabilities. The transition from sole proprietorship to LLC doesn’t immediately affect how you’re taxed.

Single-member LLCs and sole proprietorships are called “disregarded entities” because the IRS sees them as inextricably linked to their owners. Disregarded entities are defined by not having to file a separate business tax return from their owners’ Form 1040. Since there’s no business tax return for the IRS to review, they don’t distinguish business owners from their businesses.

LLCs with more than one owner are automatically taxed like partnerships, where each member is responsible for a proportionate share of income and liabilities. Members receive an IRS Schedule K-1 at the beginning of each year to tell them the amount of business income to report on their personal tax returns.

Though pass-through entities don’t pay entity-level tax, companies taxed as partnerships must file an information return with the IRS to relay business revenue and deductions. Members’ personal tax returns corroborate information return data. Since they file an information tax return, LLCs taxed as partnerships are not disregarded entities.

LLCs can also elect S corporation or C corporation taxation, each offering a suite of benefits and drawbacks.

The 3 reasons to accept the default LLC tax classification

Before you explore electing S corp or C corp taxation, consider these points.

1. You’re benefiting from pass-through taxation

Pass-through taxation means you’re only taxed once on business income. C corporations are taxed twice: once before earnings are passed onto shareholders, and again when shareholders report dividend income on their personal returns.

Have an accountant run the numbers for your business to see whether default LLC or C corp taxation produces a lower tax liability.

Pass-through taxation tends to be kinder to small business owners. C corps don’t qualify for the qualified business income (QBI) deduction, worth 20% of eligible income, and many small business tax credits.

2. It’s low maintenance

By the time you’ve registered your LLC, you’ve already filled out dozens of forms and waited weeks or months to get your approval papers. You can probably think of about 100 ways you’d rather spend that time.

So, it’s perfectly reasonable to accept your default LLC tax status because of its convenience. Your other options — C corporation or S corporation status — require a good deal of paperwork and bureaucracy that deters many business owners.

There are many self-employment tax software options for LLCs taxed as their default classification. If you elect special taxation, a tax preparer is almost always a must.

3. Uniform state and federal tax treatment

If you’re thinking about electing S corporation taxation for your LLC, check with your state tax authority first. S corporations are a federal tax classification that not every state recognizes.

A handful of states and Washington, D.C. don’t recognize S corporations. Businesses registered in one of those states may be taxed as a C corporation on the state level but as a pass-through entity for federal taxes. That’s confusing, which is code for “expensive,” in the business world.

What are the specific taxes an LLC pays?

LLCs may not all pay income taxes the same way, but they’re subject to many of the same business taxes.

1. Payroll taxes

Any organization with employees must withhold and remit payroll taxes from their employees’ paychecks. They’re also responsible for employer-paid payroll taxes.

Employers and employees each pay 7.65% of employee gross wages in Medicare and Social Security taxes or Federal Insurance Contributions Act (FICA) taxes.

LLCs also pay state (SUTA) and federal unemployment (FUTA) taxes based on employee earnings.

2. Self-employment tax

By default, LLC members are self-employed, and FICA or FUTA don’t apply to their earnings. Instead, LLC members pay self-employment taxes, equal to the employee and employer portions of FICA, 15.3% of business income.

Since the self-employed generally don’t qualify for unemployment benefits, they don’t pay unemployment taxes on their earnings.

Members of LLCs taxed as S corporations or C corporations are not considered self-employed, so they don’t pay self-employment taxes on their income. Instead, they pay payroll taxes on their salaries and federal and state income taxes on dividend income.

3. Sales and excise taxes

LLCs pay sales and excise taxes on all applicable business purchases.

4. Federal and state income tax

LLC business income is taxed on your personal income tax return unless you elect C corp taxation. Your LLC’s tax status determines which business income schedule you attach to Form 1040.

5. Corporate tax

Unlike pass-through structures, C corporations are tax entities separate from their owners. Only companies taxed as C corps pay corporate tax, which sits at 21% in 2020.

Should you elect another LLC tax classification?

Each tax classification available to LLCs offers something unique. Talk to a tax professional and peruse The Blueprint’s guide on LLC taxes to determine which is best for your business.

If you’re thinking about electing another tax classification, you’re looking at either C corp or S corp taxation. To file for C corp treatment, file Form 8832. For S corp taxation, file Form 2553.

In general, the C corp structure is more of a burden than it’s worth for small businesses. C corporation tax filings often require an accountant’s help, and you have to have a board of directors that meets annually. The administrative load is a nonstarter for many small businesses.

I recommend looking into S corporation taxation, however. S corps are pass-through entities like the default LLC tax structures, but owners are considered employees, not self-employed.

Herein lies a critical difference between S corp and LLC taxation: S corp owners earn salaries and dividend distributions, a tax-advantaged compensation structure. Where LLC members pay self-employment taxes on their entire portion of business income, S corp owners only pay FICA taxes on the salary portion of their pay. To protect against abuse, S corp owners must take a reasonable salary before earning dividend distributions.

Consider two businesses, an S corp and a single-member LLC, that earned $500,000 last year before paying their owners.

The S corp owner, called a shareholder, earned a $250,000 salary, taking the remaining $250,000 as dividends. FICA taxes apply only to the $250,000 salary.

The LLC owner doesn’t fare as well, owing self-employment taxes on the entire $500,000.

Classify yourself informed

There’s a lot to consider before changing how your LLC is taxed, so don’t rush it. You can elect a new LLC tax classification on day one or year 50, but you’ll have to wait five years before changing it again.

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