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How to Choose Your LLC Tax Status

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Published on January 25, 2022

Updated on January 27, 2022

How to Choose Your LLC Tax Status

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How to Choose Your LLC Tax Status

A limited liability company (LLC) has many advantages, including flexibility when it comes to taxes. LLCs also have flexibility in terms of management and, as suggested by the name, offer some personal liability protection.

To learn more about LLCs, read this Step By Step article.

How LLCs Are Taxed

LLCs are unique in terms of taxation as their owners have a choice about how the company will be taxed. By default, an LLC is taxed like a sole proprietorship if it has one member, and like a partnership if it has more than one member.

In both cases, business income “passes through” the company to the members, who report profits and losses on their individual tax returns. The LLC itself is not taxed, which simplifies the process for members. Also, losses and operating costs of the business can be deducted personally by the members. Taxes are paid at the personal tax rate of the members, although the owners may also have to pay self-employment taxes. 

Note that a multi-member LLC must also file form 1065 with the IRS, which is the Return of Partnership Income. Attached to this will be K-1 forms for each member showing their share of the business income. 

But LLC owners can instead choose to be taxed as a corporation. To do so, the LLC must file a document, referred to as an election, with the IRS. The LLC must then decide if it wishes to be taxed as an S corporation or a C corporation.

C Corp status means profits are taxed at the current rate for corporations (21% as of early 2022), which is significantly lower than the typical individual taxpayer rate. But keep in mind, C Corp shareholders, which includes members, must also pay taxes on their distributions (but not self-employment taxes). Thus, the C Corp is subject to what is sometimes referred to as double taxation. 

As with sole proprietorship and partnership status, S Corp taxation considers the LLC a pass-through entity, which means income passes through the company and into the hands of the owners. At this point, taxes are applied at the same rate as those of individual taxpayers.

S Corps use Form 1120S to file their taxes, which is used to report the income, losses, and dividends of shareholders. S Corp shareholders do not pay self-employment taxes, which is the primary advantage of S-Corp status compared to sole proprietorship or partnership. 

Choosing S- Corp Status

To be eligible for S Corp status you have to meet the following IRS requirements:

  • Be a domestic corporation
  • Have only allowable shareholders
    • May be individuals, certain trusts, and estates and
    • May not be partnerships, corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

Generally, S Corp tax status is beneficial if the company is profitable enough to pay the owners a salary and at least $10,000 in annual distributions. This way the owners can be taxed as employees and not pay self-employment taxes.

It costs more to run an S Corp than an LLC due to additional bookkeeping and payroll expenses. Thus, the tax benefits should be more than the additional costs for S Corp status to make financial sense. To elect S Corp status you simply need to file form 2553 with the IRS. 

Choosing C Corp Status

To determine if C Corp status is beneficial, calculate which taxes you’ll pay if you do not elect C Corp status, based on your personal income tax rate, and add in self-employment taxes. LLC owners also may be eligible for the 20% pass-through deduction as part of the Tax Cuts and Jobs Act, meaning they can deduct up to 20% of business income. If you’re eligible for this deduction, factor that into your calculations.

Next, determine which taxes you’ll pay if you choose C Corp status. This will include corporate taxes, taxes on dividends paid (if you plan to pay dividends), and any salary tax. Then you need to add in the costs involved in running a C Corp for bookkeeping and payroll expenses. There will be no self-employment taxes and no pass-through deduction.

In general, however, the main advantage of choosing C Corp status is that it makes it much easier to attract investors. Shares of a C Corp can be easily transferred or sold, which makes a corporation much more attractive to investors. To choose C Corp status, file form 8832 with the IRS. 

In Closing

When it comes to LLCs, the tax status decision can be difficult. To ensure you make the right choice, you should speak with your tax advisor. They can look at you and your firm and tell you the benefits of each option based on your situation. It’s an important decision, so professional advice is the wise move. 

To learn more about the benefits of an LLC, read this Step By Step Article, or learn how to start an LLC.