How Is My LLC Going to Be Taxed? Disregarded Entities, Partnerships, and S-Corps Explained
Starting an LLC is an exciting step for any entrepreneur, but understanding how your LLC will be taxed is just as important as forming the business itself. The IRS provides default tax classifications for LLCs, but you can also choose to change how your LLC is taxed to better suit your financial and business goals.
In this blog, we’ll break down the default IRS tax classifications, what it means to be a disregarded entity or partnership, and how you can elect to be taxed as an S corporation or C corporation for potential tax savings.
Default Tax Classifications for LLCs
When you form an LLC, the IRS does not assign a specific tax category to the business itself. Instead, LLCs are taxed based on the number of members (owners) and their tax elections.
Single-Member LLCs: Disregarded Entity
What It Means: By default, a single-member LLC is treated as a disregarded entity for federal tax purposes.
Taxation: The LLC’s income, expenses, and deductions are reported on the owner’s personal tax return using Schedule C (for sole proprietors), Schedule E, or Schedule F, depending on the type of income.
Key Advantage: Simplified tax filing, as there’s no separate business tax return required.
Multi-Member LLCs: Partnership
What It Means: By default, a multi-member LLC is treated as a partnership for federal tax purposes.
Taxation: The LLC files a Form 1065 (U.S. Return of Partnership Income) and issues K-1 forms to each member, detailing their share of income, deductions, and credits. Members report this information on their personal tax returns.
Key Advantage: Pass-through taxation avoids double taxation (where income is taxed at both the business and personal levels).
Electing S Corporation Tax Status
LLCs can choose to be taxed as an S corporation by filing Form 2553 (Election by a Small Business Corporation) with the IRS. This election can offer tax benefits, especially for businesses with significant profits.
Key Features of S Corp Taxation:
Pass-Through Taxation: Like disregarded entities and partnerships, S corps are pass-through entities, meaning the income flows through to the owners’ personal tax returns.
Potential Tax Savings: Owners who are also employees of the business can pay themselves a reasonable salary, which is subject to payroll taxes, and take the remaining profits as distributions, which are not subject to self-employment taxes.
Requirements for S Corps:
Must have 100 or fewer shareholders.
All shareholders must be U.S. citizens or residents.
Must issue only one class of stock.
Example of Tax Savings with an S Corp:
LLC Owner’s Total Income: $100,000
As an S Corp: Pay yourself a $60,000 salary (subject to payroll taxes), and take the remaining $40,000 as a distribution (not subject to self-employment tax). This can save thousands in taxes compared to the default LLC taxation.
Electing C Corporation Tax Status
While less common for LLCs, you can also elect to be taxed as a C corporation by filing Form 8832 (Entity Classification Election) with the IRS.
Key Features of C Corp Taxation:
Separate Taxable Entity: Unlike pass-through taxation, the C corp pays taxes on its income at the corporate tax rate.
Double Taxation: Shareholders pay taxes on dividends received, which can lead to double taxation of profits.
Advantages of C Corp Status:
Easier to reinvest profits into the business without passing income to the owners.
Potential for lower tax rates on retained earnings, depending on the corporate tax rate.
When C Corp Status Makes Sense:
For businesses that plan to reinvest most of their profits into growth.
For companies seeking outside investors or planning to go public.
Key Differences Between LLCs and S Corps
It’s important to note that an LLC and an S corp are not mutually exclusive. An LLC is a legal structure, while an S corp is a tax election.
How to Make a Tax Election for Your LLC
If you want to change your LLC’s tax classification, here’s how to do it:
Electing S Corp Taxation:
File Form 2553 with the IRS within 75 days of forming the LLC or by March 15th for the election to apply to the current tax year.
Electing C Corp Taxation:
File Form 8832 to change your classification to a C corp.
Work with a Tax Professional:
Tax elections can have long-term implications. Consulting with an accountant or attorney ensures you’re making the right choice for your business.
Which Tax Classification Is Right for You?
The best tax classification for your LLC depends on several factors, including:
Your income level.
Whether you plan to reinvest profits or take distributions.
Your business growth strategy.
Your preference for simplicity versus tax savings.
Take the Next Step to Maximize Tax Savings
At our offices in Detroit, Dearborn, and Royal Oak, we help small business owners across Southeast Michigan navigate LLC formation, tax elections, and estate planning to protect their businesses and minimize taxes. Let’s work together to find the best strategy for your business.