A deeper look at the various LLC tax classifications
Federal Tax Classifications
When LLCs were first invented the IRS decided not to create a new tax classification, but rather allow the LLC to choose from the existing tax classifications (sole proprietorship, partnership, or corporation).
Unless you tell the IRS otherwise, a single-member LLC will be taxed as a sole proprietorship; and a multi-member LLC is taxed as a partnership. Tax flexibility is one of the reasons the LLC is so popular. Below you can read about the various tax classifications available to a Texas LLC.
Disregarded Entity (Single-Member LLC)
A single-member LLC is treated by the IRS as a “disregarded entity”. This means the profits simply pass-through the owner. Most single-member LLC are owned by an individual and thus the LLC is tax like a sole proprietorship for federal tax purposes. Just like a sole proprietor, the member will report business profits on Schedule C of his/her personal Form 1040 tax return. The member will pay income tax on the profits at their individual tax rate as well as an additional 15.3% in self-employment taxes (social security and medicare). Read more about single-member LLCs →
Partnership (Multi-Member LLC)
An LLC can elect to be taxed like an S-Corporation by filing Form 2553 (aka the S-Corp Election). The reason an LLC would make this election is to reduce the self-employment tax obligations of the LLC’s owners. Any member who works in or helps manage the LLC business must pay social security and medicare (these are often jointly referred to self-employment taxes) on his/her share of profits. One way to reduce the self-employment tax obligation is to elect for the LLC to be taxed as an S-Corp. Any owner who is also a salaried (w-2) employee of the LLC, will pay self-employment taxes on his/her salary (not his/her share of the profits). The salary must be reasonable.
Read more about S-Corp LLCs →
What is required to be taxed as an S corporation?
Why would an LLC want to be taxed as an S corporation?
What is the definition of an S Corp?
Can an S-Corp Election be revoked?
An LLC can elect to be taxed like a C-Corporation by filing Form 8832. Each of the tax classifications above are all “pass-through” classifications meaning the LLC’s profits pass-through to the owners who then pay income tax on their portion of the profits (regardless of whether the LLC chooses to retain the profits for future use or distribute profits to the members).
An LLC taxed as a C-Corporation is not a pass through entity. This means the LLC will file a corporate tax return and pay corporate taxes on the profits. As of the writing of this article, the Trump Tax plan would reduce the Corporate tax rate to 21% (down from 35%). The owners would also pay income tax on any distributions or dividends they receive from the C-Corp LLC. This is sometimes referred to as double taxation and one of the big reasons a C-Corp LLC is rare. Read more about Corporate Taxation →