No one type of classification is inherently better than another. Each person and business must consider a number of factors and apply them to his or her specific situation.
You can't make an intelligent decision on your best tax classification because an online service tells you that a certain percentage of people who responded to a series of questions with answers similar to yours chose a specific type of entity.
Need to KnowIt’s Tax time! And as the flowers have begun to bloom, your business has been in “tax mode” for some time, I’m sure! Don’t let tax time stress you out! We will be having a month long “All Things taxes” blog series to hopefully answer any questions or give a bit of information for next year’s taxes.
All new LLC owners must address LLC tax classification for their business. Unlike some other business forms, there are different ways that an LLC can be classified for tax purposes. There are three primary options for LLC tax classification: disregarded entity, partnership, and corporation. Within the corporate classification there are two sub-options: C corporation and S corporation. Some of these classifications require forms to be filed with the IRS while others occur by default.
There is no single correct choice for classification, what is best for the LLC and its owners will depend on a number of factors like business size, members’ goals, and financial plans for the LLC.
LLC Tax Classification OptionsLLCs have multiple options for how they will be classified for tax purposes because they are hybrid entities that combine the advantages of different business forms. LLCs are designed to be flexible entities, and that flexibility carries over to tax classification. Because they are hybrids and are created by state law, the IRS does not recognize LLCs as a distinct, unique type of business for tax purposes.
LLCs have three primary options when it comes to tax classification. These classifications just indicate how the entity will be taxed. They do not change the type of entity. In other words, electing corporation taxation classification with the IRS does not change an LLC into a corporation. The business is still an LLC for all non-tax purposes but it is taxed like a corporation. The owners are still called members, the operating agreement is still the governing document, and so on.
Disregarded Entity. LLCs can be classified as pass-through entities for tax purposes. This basically means they will be treated like a sole proprietorship where the LLC and the owner are considered one-and-the-same for tax purposes. Under this classification, the single LLC owner is basically self-employed for tax purposes and must file and pay the same self-employed tax forms as individuals freelancing or operating a business in their personal name.
Partnership. LLCs with multiple members can be classified as partnerships for tax purposes. Like LLCs taxed as disregarded entities, LLCs taxed as partnerships are treated as pass-through entities and individual owners are taxed for the LLCs profits and losses. Under this classification, even if LLC owners do not actually receive their percentage of the profits (they are left in the LLCs bank account), they are still taxed on those profits as though they had received them.
Unlike disregarded entity classification, under partnership classification, the LLC itself still has to report certain information to the IRS on its own behalf even though the entity itself is not taxed. The LLC must also prepare certain forms and send them to owners to assist them in their own filings.
Corporation Classification. LLCs of all sizes, including single-member LLCs, can choose to be classified like corporations for tax purposes. If they choose this option, then both the LLC and the individual have reporting requirements. However, if s-corporation status is elected, the corporation will not have to pay federal taxes on profits; instead they will pass through to the LLCs owners who will include them on their individual taxes.
How to Select Your LLCs Tax ClassificationDefault Classifications. If you take no action, the IRS has default rules about how your LLC will be classified for tax purposes based on how many members (owners) it has. By default, multi-member LLCs are taxed like partnerships and single-member LLCs are taxed like sole proprietorships as disregarded entities. If you select to be taxed as a corporation on your Form 8832 and take no other action, by default the IRS will treat your entity as a C corporation.
Electing a Non-Default Classification. If you do not want the default rules to apply to your LLC, you must file an IRS Form 8832 with the IRS. On the form, you will select how you want your LLC to be classified for tax purposes. In most cases, the form must be filed within 75 days of the LLCs formation, or if that deadline is missed, within 75 days of the next tax year. In limited circumstances, late elections will be honored. Be sure to consult necessary advisors before making your decision and filing your Form 8832 because tax status can usually only be changed once every five years.
Electing S Corporation Status. As mentioned above, if you would like to elect S corporation status for your corporation, you must file IRS Form 2553 with the IRS within the same 75 day timelines as your Form 8832.
State Tax Classification for LLCsBecause laws vary so much from state to state, it is harder to provide general guidance on state taxes. However, LLCs should be aware that in addition to their federal tax obligations, they are also responsible for completing the pertinent tax forms and paying applicable fees at the state level.
Overall, states tend to follow the classification elected at the federal level, so similar forms are often used. A number of states impose additional taxes and/or fees on LLCs operating within their borders.
Consult with your state’s tax board or your accountant or tax attorney for guidance on your LLC’s state tax and fee obligations.
You should now understand that making an informed and intelligent decision when choosing the "best" tax classification for your entity, requires consideration of many factors. You need to balance pros and cons and possibly make some trade-offs to make the best choices for your particular business.
If you’re still a little confused about what the best tax classification for your LLC is or could otherwise benefit from sound legal advice, you can contact our office and we can help with any questions you may have.