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LEGAL DICTIONARY

LLC Tax Classification

What Is an LLC Tax Classification?

When you form a limited liability company (LLC), you have a few options for how your business will be taxed. The decision you make depends on the size of your business and your goals. The type of tax classification does not change the type of entity, only how the IRS will tax the entity.

The three main options for LLC tax classification are disregarded entity, partnership, and corporation. Within the corporation classification, C corporation (C corp) and S corporation (S corp) are two sub-categories.

Disregarded Entity

The simplest and most common tax classification for single-member LLCs is the disregarded entity. Under this classification, the LLC's income passes through to the sole owner, who pays income tax on their personal tax return. The advantage of this classification is that the LLC income is only taxed once.

A disadvantage of this tax status is that the owner is taxed on all LLC income, even earnings that remain in the business account at the end of the year and are targeted for future expenses.

Partnership

LLCs with multiple owners/members can be taxed as partnerships. Like disregarded entities, LLCs with the partnership classification are pass-through entities, meaning individual owners are responsible for paying tax on the LLC's profits.

A downside is that LLC owners are taxed on profits even if they remain in the company bank account. Also, the LLC must prepare tax forms and issue them to its owners as part of its partnership agreement.

Corporation

LLCs of all sizes —even single-member LLCs— can choose to be a corporation as their tax classification. For this tax status, both the LLCs and the individuals have tax reporting requirements. There are two sub-categories to the corporation tax classification.

S Corporation (S corps): This tax status is available to corporations and LLCs. S corps offer "pass-through" taxation, meaning all taxes are the personal tax obligations of the LLC's owners. Any money remaining in the business at the end of the year can be distributed to active shareholders as dividends, thereby reducing the owners' tax obligations.

In order to qualify as an S corp, a business must meet the following criteria:

  • Have allowable shareholders, including individuals, certain trusts, and estates but no partnerships, corporations, or non-resident shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock

C Corporation (C Corp): The LLC is taxed directly as a separate business entity under this classification. In other words, business income is not passed through to the owner's personal taxes.

The LLC must file an income tax return, and the LLC owners must also file their personal income taxes.

Although C corps are taxed at both the corporate and the personal levels, this separation allows businesses to take advantage of some deductions. Another advantage of this classification is C corps can have an unlimited number of shareholders or investors, and there are no restrictions on who can hold shares.

How to Decide What Tax Classification Is Right for You

The decision to establish an LLC vs. a sole proprietorship is a big one. Although the laws governing LLCs can vary from state to state, one of the main benefits of an LLC is the protection the structure offers its owners from personal responsibility for its liabilities or debts.

Your LLC's tax structure is another important decision. If you do not take action, the IRS has default regulations that will make the decision based on your business registration number. Here is how the default rules work:

  • Without action, single-member LLCs are considered disregarded entities.
  • By default, multi-member LLCs are taxed like partnerships.
  • If you choose corporation as your status and take no other action, the IRS will classify your entity as a C corp.

If you do not want the default rules to apply to your LLC, you must tell the IRS how you want your LLC to be classified for tax purposes. In most cases, you must file an IRS Form 8832 within 75 days of the LLC's formation.

The tax classification you choose will be part of your LLC operating agreement and your LLC’s articles of incorporation. Your LLC’s registered agent is responsible for filing the correct forms that correspond with your tax classification.

Helpful Resources:

Fresh Books - Tax Classifications for LLC: Everything You Need to Know

SimplifyLLC - How to Choose a Tax Classification for an LLC

TRUiC - How to Choose Your LLC Tax Status

Internal Revenue Service - Limited Liability Company (LLC)

Internal Revenue Service - LLC Filing as a Corporation or Partnership

Small Business Chronicles - Can an LLC Choose to Be Taxed Differently Every Year?

Investopedia - LLC vs. S Corporation: What's the Difference?

What Is an LLC Tax Classification?

When you form a limited liability company (LLC), you have a few options for how your business will be taxed. The decision you make depends on the size of your business and your goals. The type of tax classification does not change the type of entity, only how the IRS will tax the entity.

The three main options for LLC tax classification are disregarded entity, partnership, and corporation. Within the corporation classification, C corporation (C corp) and S corporation (S corp) are two sub-categories.

Disregarded Entity

The simplest and most common tax classification for single-member LLCs is the disregarded entity. Under this classification, the LLC's income passes through to the sole owner, who pays income tax on their personal tax return. The advantage of this classification is that the LLC income is only taxed once.

A disadvantage of this tax status is that the owner is taxed on all LLC income, even earnings that remain in the business account at the end of the year and are targeted for future expenses.

Partnership

LLCs with multiple owners/members can be taxed as partnerships. Like disregarded entities, LLCs with the partnership classification are pass-through entities, meaning individual owners are responsible for paying tax on the LLC's profits.

A downside is that LLC owners are taxed on profits even if they remain in the company bank account. Also, the LLC must prepare tax forms and issue them to its owners as part of its partnership agreement.

Corporation

LLCs of all sizes —even single-member LLCs— can choose to be a corporation as their tax classification. For this tax status, both the LLCs and the individuals have tax reporting requirements. There are two sub-categories to the corporation tax classification.

S Corporation (S corps): This tax status is available to corporations and LLCs. S corps offer "pass-through" taxation, meaning all taxes are the personal tax obligations of the LLC's owners. Any money remaining in the business at the end of the year can be distributed to active shareholders as dividends, thereby reducing the owners' tax obligations.

In order to qualify as an S corp, a business must meet the following criteria:

  • Have allowable shareholders, including individuals, certain trusts, and estates but no partnerships, corporations, or non-resident shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock

C Corporation (C Corp): The LLC is taxed directly as a separate business entity under this classification. In other words, business income is not passed through to the owner's personal taxes.

The LLC must file an income tax return, and the LLC owners must also file their personal income taxes.

Although C corps are taxed at both the corporate and the personal levels, this separation allows businesses to take advantage of some deductions. Another advantage of this classification is C corps can have an unlimited number of shareholders or investors, and there are no restrictions on who can hold shares.

How to Decide What Tax Classification Is Right for You

The decision to establish an LLC vs. a sole proprietorship is a big one. Although the laws governing LLCs can vary from state to state, one of the main benefits of an LLC is the protection the structure offers its owners from personal responsibility for its liabilities or debts.

Your LLC's tax structure is another important decision. If you do not take action, the IRS has default regulations that will make the decision based on your business registration number. Here is how the default rules work:

  • Without action, single-member LLCs are considered disregarded entities.
  • By default, multi-member LLCs are taxed like partnerships.
  • If you choose corporation as your status and take no other action, the IRS will classify your entity as a C corp.

If you do not want the default rules to apply to your LLC, you must tell the IRS how you want your LLC to be classified for tax purposes. In most cases, you must file an IRS Form 8832 within 75 days of the LLC's formation.

The tax classification you choose will be part of your LLC operating agreement and your LLC’s articles of incorporation. Your LLC’s registered agent is responsible for filing the correct forms that correspond with your tax classification.

Helpful Resources:

Fresh Books - Tax Classifications for LLC: Everything You Need to Know

SimplifyLLC - How to Choose a Tax Classification for an LLC

TRUiC - How to Choose Your LLC Tax Status

Internal Revenue Service - Limited Liability Company (LLC)

Internal Revenue Service - LLC Filing as a Corporation or Partnership

Small Business Chronicles - Can an LLC Choose to Be Taxed Differently Every Year?

Investopedia - LLC vs. S Corporation: What's the Difference?