The overall advantages of LLCs make it a popular choice among start-up entrepreneurs compared to the other options. After all, it provides limited liability without the hassle of paperwork, red tape and other formalities which can be tedious and complicated for a startup, a solo entrepreneur or a small business.
Most entrepreneurs learn it after forming their LLC that the next thing for them to figure out is its tax structure. This is a key decision as it is the reason why they choose the legal structure of LLC. Because the LLC is not a federal government entity, it offers flexibility as far as federal tax treatment is concerned.
When an LLC has a single member, its tax structure is based on either the concept of a sole proprietorship or a corporation (a C corporation or an S corporation). On the other hand, if an LLC has more than one member, it may be taxed as a partnership, C corporation or S corporation. While the flexibility of tax structure is the best part of LLC, figuring out the right option is the key to ensure that the takeoff of the business is smooth. In order to do so, it is important to make note of the four classifications for the LLC.
Classification of LLCs Based on Tax Structure
As it is evident from the name itself, a single–member LLC refers to a limited liability company wherein an individual remains the owner and they manage it on their own. Such an entity is taxed as a sole proprietor. It has the advantage of pass-through taxation, meaning that its owner does not need to file any tax form. They are required to file their profit or loss, based on their income, on personal tax forms.
If the owner of this category of LLC is engaged in active trade or business, they need to pay self-employment taxes. For example, if the owner copywrites or sells a product, they are required to follow this rule. However, if the purpose of forming a single-member LLC is to do a passive activity, the owner need not pay self-employment tax, regardless of whether or not they make a profit. They can report it on Schedule E.
When an LLC has more than one member or partner, it is taxed as a partnership. There is also the possibility that it could be either taxed as a C corporation or an S Corporation, provided that the owners apply for the status of the two entities. Furthermore, a partnership is taxed federally, and each partner is required to pay the employment taxes on profit from the revenue share on SE tax form. A multi-member LLC is required to file their tax return on 1065 partnership tax return.
An LLC can apply for the approval for a C Corporation by filing Form 8832 with the IRS. If recognized by a letter from the Office of the Secretary of the State, the given LLC is required to pay taxes on its profit at a corporate tax rate and is required to file a corporate tax return 1120. Further, if LLC profits are divided among its owners as dividends, an additional tax at the rate of dividend is also payable. This way of taxing an entity is called double taxation. It is one of the primary features of C corporation. However, an important aspect to understand here is that although the LLC profits are not taken into account to calculate self-employment taxes, the concept of self-employment tax is applicable for payroll taxes on the wages paid to those who work for the business. The amount of money which stays in the business is not taxed. While the tax rate on profit on the net income is 34%, the dividend rate on the dividend shared among partners is 15%.
If an LLC files Form 2553 with the IRS and elects to be treated as an S corporation, it is recognized as an S corporation after the grant of the letter of approval. Unlike a C Corporation, where the members are required to pay corporate income tax, in this scenario the owners are taxed based on their shares of the profit earned by the company. In the event of an LLC owner working for the business, he must be remunerated with a reasonable wage for the same and the LLC is required to pay the payroll taxes on the remuneration.
Thus, it is clear that after forming an LLC, the choice of the right tax entity among the four options as stated above depends on the business needs, circumstances and vision. A careful observation of the changes in federal and state tax development, which has a bearing on the taxes, can come in handy in making an informed decision in this regard. Given the significant financial implication of the decision, it is strongly recommended that the owners should discuss the options with a CPA or a tax adviser.