The limited liability company (LLC) form of business is the newest invention in business forms, adding simplicity of organization to liability protection. An LLC can be taxed in several different ways to save on taxes for the business and its owner.
In this article we'll look at the LLC form of business, how an LLC is usually taxed, how being taxed as a corporation or S corporation can benefit your business, and the process of electing this tax option.
How LLCs Are Taxed
By default, your LLC is taxed in one of two ways, depending on how many owners (called "members") are in the LLC:
- A single-member LLC is considered a disregarded entity and is taxed as a sole proprietorship, filing Schedule C to for the individual's personal tax return.
- A multiple-member LLC is taxed as a partnership. The partnership files an information return on Form 1065, with Schedule K-1's for each member/partner.
LLC member taxes are based on their share of the income of the business for the year. No matter how much or how little LLC members take out of the business for personal use, they are taxed on the full amount of the annual net income of that business.
LLC Owners and Self-Employment Taxes
In addition to paying income taxes based on their business income, LLC owners are normally considered to be self-employed, and they must pay self-employment tax (for Social Security and Medicare) on their income from the LLC.
FICA Tax vs. Self-Employment Tax
Social Security and Medicare tax is called FICA tax for employees and self-employment tax for self-employed individuals, including business owners. It's the same tax and the same total amount, except that FICA taxes are shared by employees and employers and self-employed people pay the full amount of the tax.
If the LLC elects to be taxed as a corporation, corporate tax rules apply. That means the corporation itself is taxed. The corporation pays income tax on its net earnings and the owners/members pay income tax on any dividends they receive.
If the LLC elects to be taxed as an S corporation, the owners don't have to pay self-employment tax because S corporation owners aren't considered to be self-employed. Most S corporation owners work in the business as employees and they pay FICA taxes on this income from employment.
LLC Taxed as a Corporation
Many LLCs choose to be taxed as corporations to save on taxes. In this tax situation, the LLC members become shareholders and they are not self-employed.
For higher-income individuals or those with profitable LLCs, the fact that corporate shareholders don't have to pay tax on their share income of the corporation is a tax advantage. The corporate rate (a flat 21%, beginning with the 2018 tax year) may be lower than the higher tax rates for personal income taxes.
You also avoid having to pay self-employment tax, unless you work in the corporation as an employee (and pay FICA tax).
Let's look at a scenario:
Your LLC has a net profit of $50,000 for the year. If you are the only owner of the LLC, you must take all of this profit on your personal income tax return. If you have the LLC taxed as a corporation, the corporation pays tax on this income, but you as a shareholder only pay tax if you receive dividends.
One big advantage of an LLC over corporations is that owners avoid double taxation, where the corporation pays taxes on its net earnings for the year and shareholders pay tax on income received as dividends.
The Main Advantage and Disadvantage of LLC Taxed as Corporation
The main advantage of having an LLC taxed as a corporation is the benefit to the owner of not having to take all of the business income on your personal tax return. You also don't have to pay self-employment tax on your income as an owner from the corporation.
The main disadvantage is double taxation. The corporation must pay tax on its net earnings and you as an owner must pay tax on any dividends you receive.
LLC Taxed as an S Corporation
An S corporation is a special kind of corporation that has some tax advantages. Owners can split their income from the S corporation between a distribution (in the same way as a partner in a partnership) and status as an employee. An S corporation owner who works in the business must be paid a reasonable salary as an employee and must pay tax and FICA tax on this salary.
Because the S corporation profits are distributed to owners, this tax status avoids the double taxation situation.
To qualify to be taxed as an S corporation, the business must meet specific requirements:
- the business can have no more than 100 shareholders
- no shareholder can be a nonresident alien (noncitizen who doesn't live in the U.S.
- there can be only one class of stock
- all shareholders must be individuals (not other businesses)
Another advantage of S corporation status is that an S corp owner can take a 20% tax deduction from his or her share of business income, in addition to usual deductions for business expenses. This Qualified Business Income (QBI) deduction is calculated on the owner's income as an employee. This deduction is not available for personal service businesses like accounting, law, consulting, or financial services. Also, the QBI deduction is limited or not available for higher-income business owners.
Many LLC's choose the S corporation for its tax status because:
- It avoids the double taxation situation of corporations
- S corporation owners can take the QBI deduction on business income (not employment income)
- Owners pay Social Security/Medicare tax only on employment income.
How to Make the Election
If you decide to make this election, here is some more information you need to know:
To be taxed as a Corporation, use IRS Form 8832 — Entity Classification Election. The election to be taxed as the new entity will be in effect on the date entered on line 8 of Form 8832. The election cannot take effect more than 75 days before the date the election is filed, nor can it take effect later than 12 months after the date the election is filed.
The form includes a consent statement which may be signed by all members, or by one member on behalf of all members. If one member signs, there should be some record in company membership meetings that all members approved this election.
You must provide the name(s) and identifying the number(s) of owners (Social Security Number for a single-member LLC, and Employer ID Number for multiple member LLC).
To be taxed as an S Corporation, use IRS Form 2553 - Election by a Small Business Corporation. To begin the new tax classification for a year, you must file by March 15, effective for the entire year. You will need to include information about each shareholder: name and address, shares owned, Social Security number, the date the owner's tax year ends, and a consent statement.
What Happens to the Old Entity
For a change to a corporation, when your election to corporate status becomes effective, the IRS determines that all the assets and liabilities of the previous business (sole proprietorship or partnership) are contributed to the corporation in exchange for shares of the corporate stock.
Disclaimer: This information is provided to give you a general knowledge of the subject and to allow you to have information to discuss with your attorney, CPA, or tax adviser. Every business situation is unique, and taxes and laws change regularly.