How LLCs are taxed: the four options

Why there are four options

Federal tax law does not have a category called "LLC". Under the IRS entity classification rules, an LLC is taxed as one of the categories that do exist: a sole proprietorship or division of its owner, a partnership, or a corporation. A corporation can then be a C corporation or, if it qualifies and elects, an S corporation. That gives four possibilities. Three of them are pass-through treatments. See pass-through taxation explained.

The four options side by side

1. Disregarded entity

An LLC with one owner is ignored for federal income tax unless it elects otherwise. If the owner is an individual, the business income and expenses go on Schedule C of the owner's Form 1040, and the profit is subject to income tax and self-employment tax. If the owner is a company, the LLC is treated as a branch of that company.

Two points are easy to miss:

• The LLC is still a separate entity for some federal purposes, such as employment taxes and certain excise taxes, so it uses its own EIN for those.
• If the owner is a foreign person, the LLC files Form 5472 with a pro forma Form 1120 each year it has reportable transactions, even though it owes no tax as an entity.

A disregarded LLC can also own other LLCs, which is how most holding structures work. See holding company LLCs.

2. Partnership

An LLC with two or more owners is taxed as a partnership by default. The LLC files Form 1065, an information return, and gives each member a Schedule K-1 showing their share of income, deductions and credits. The members pay the tax on their own returns, whether or not the profit was paid out to them. Members who work in the business generally pay self-employment tax on their share, and payments to a member for their work are usually guaranteed payments rather than wages.

The operating agreement can split profit differently from ownership, within the tax rules, which is one reason partnerships suit businesses with unequal contributions. See single-member vs multi-member LLC.

3. C corporation

An LLC can elect to be taxed as a corporation by filing Form 8832. It then files Form 1120 and pays federal tax on its profit at a flat 21%. Profit paid out to owners as dividends is taxed again on the owners' side. Owners who work in the business are paid a salary through payroll.

This option suits businesses that keep most of their profit to reinvest, or that need corporate treatment for investors. It is also open to foreign owners, who cannot use S status.

4. S corporation

An LLC that meets the S corporation rules can elect S status on Form 2553. It does not need to file Form 8832 first, because a valid S election also treats the LLC as a corporation. The LLC files Form 1120-S. Profit passes through to the owners, who must take a reasonable salary through payroll if they work in the business. The rest can be paid as distributions that are not subject to payroll tax.

The rules are strict: generally no more than 100 shareholders, who must be US citizens or residents or certain trusts and estates, and one class of ownership. Whether the election saves money depends on profit level and costs. See when an S corp election saves tax.

Changing classification

Form 8832

Form 8832 is used to choose corporate treatment, or to change classification later. The election can take effect up to 75 days before the date it is filed, or up to 12 months after. Once an LLC has changed classification by election, it generally cannot change again for 60 months.

Form 2553

To take effect for a tax year, the S election is generally filed no later than 2 months and 15 days after that year begins, or at any time in the year before. All shareholders must consent. The IRS offers relief for late elections in some circumstances.

Changing is not always tax-free

Moving from partnership or disregarded treatment to a corporation is usually straightforward. Moving from a corporation back to pass-through treatment is treated as a liquidation of the corporation, which can create tax on the company's assets and on the owners. Think carefully before electing corporate treatment if you may want to reverse it.

The election itself is explained in Form 8832: choosing how your entity is taxed.

State treatment

Most states follow the federal classification for income tax. Some also charge LLCs their own taxes or fees whatever the federal choice. California, for example, charges every LLC an $800 minimum annual tax, and Texas applies its franchise tax to LLCs above its revenue threshold. Check your state before assuming that pass-through treatment means no state tax at the LLC level. See franchise tax explained.

Choosing

• Keep the default while the business is small, or when you are a foreign owner with no US business activity.
• Consider S status once profit is steady and high enough that the payroll tax saving outweighs the extra costs.
• Consider C corporation treatment if you reinvest most profit, need investors, or are a foreign owner with US operations and want a single corporate taxpayer.

For the wider choice between forming an LLC or a corporation in the first place, see LLC vs S corp vs C corp.

This guide is general information. It is not tax or legal advice for your situation.