How do you decide how your LLC will be taxed?

By Michael Banner - Sep 16, 2013     

 How do you decide how your LLC will be taxed?

After your limited liability has been formed, you have a choice to make:  how your LLC will be taxed by the IRS going forward!

Maybe you’ve been told, “an LLC is taxed only one way.”  But, that simply isn’t true.  However, choosing your entity’s tax status is not as simple as it may look.

There are several issues you must consider first before making your choice.

I will try to give you an overview of the options you have and how best to choose one.

Isn’t the choice made for me?

No!  When an LLC is formed with the state, it is basically tax neutral.  In other words, there has not been an assignment of how the LLC will be taxed until you make that election.  However, if none is made, the IRS and perhaps even your formation state will choose a default for you.  This maybe the route you go, but it is still your right to choose how your LLC will be classified for tax purposes.

When does the IRS first assign a tax status to your LLC?

The IRS does not even become aware of your LLC when it is formed with the state.  Until your LLC obtains an Employer Tax ID Number (or EIN), the IRS will not consider your LLC active enough to classify it for tax status.  Once an EIN is obtained, the IRS will assign a tax status by default.  .

How the IRS “default” is determined?

The default method of taxation by the IRS is dependent on how many members (owners) are listed on the EIN application.  If the LLC lists only one member, then the IRS will tax as “Disregarded Entity.”  If there are two or more owners, the IRS will tax the LLC as a “Partnership.”

NOTE:  Even if you tell the IRS on the EIN application that the LLC is to be taxed as a C Corp. or S Corp., they will still go with one of these two defaults:

Taxed as Disregarded Entity

A “disregarded entity” means what it says; for the purposes of taxation, the IRS will disregard the entity and tax it as a sole proprietorship.  It doesn’t mean that the LLC is disregarded or considered lesser, when it comes to liability protection.  It just means that for the purposes of reporting your business income, you will still file a Schedule C and show your business income on line 12 of your 1040 personal tax return, just as it would if you personally owned your business as a sole proprietorship. 

NOTE:  You will still be considered a separate entity for the purposes of employment taxes and excise taxes.

Taxed as a Partnership

If your LLC is taxed as a partnership, then every tax year, your LLC will be required to file a Partnership Return or Form 1065 and Schedule K-1 for each partner/owner.
 

What about a Corporation?

An LLC can also be taxed as a corporation.  But to do this, it must file IRS Form 8832 (Entity Classification form) electing to be taxed as a regular corporation (sometimes called a “c corporation”).
 

What about an S Corporation?

If you wish your LLC to be considered an S Corporation for tax purposes, you can file a separate election to the IRS.  In addition to the Form 8832, you would have to file Form 2253, also known as an S Election form. 

Please Note:  Your LLC must file both forms and it must be done in a timely basis to be effective in the same tax year.  For more information, see Form 8832 instructions.
 

What about state taxes?

Often state’s will tax your LLC as you have elected to be taxed by the IRS, but that is not always the case, especially if electing to be taxed as a Corp.  For instance, if you elected to be taxed as an S Corp. for federal taxes, your state may still require you to file a regular LLC tax return.  You should check with your formation state and find out how they will treat your LLC. 

For more info on your state’s taxes, choose your state below:

 

Making changes

The good news is that you can almost always change how your LLC is taxed.  The bad news is, you must be timely when you make an election and if you elect to be taxed as a C Corp. or S Corp., you generally cannot change your classification for 60 months.   Changing your LLC’s classification from a disregarded entity or partnership to a corporation does not involve the same limitations.  However, there are requirements about when you must make your election, especially if you are on a short tax year (i.e. your first tax year).

Try a licensed accountant

I am a big believer in finding and using a good accountant.  This is because your job as a small biz owner is to make money and make your business grow:  It is not to be a tax expert, who is up on the latest tax schemes.  A good accountant, cannot only help you file your business taxes, he/she can also provide consulting on what tax method is best for your LLC.

Whether you use an accountant or make your choices and elections on your own, the LLC certainly provides you with multiple taxation options.  So, make your choice a good one.

 

About Michael Banner
  CEO & Founder of SmallBiZ.com, created over seventeen years ago to help small business owners simplify the process of starting & managing their small businesses. SmallBiZ.com now serves over 10,000 businesses per year with various filing and subscription services; in addition to the 1000's of daily visitors to www.smallbiz.com, accessing free services, help pages, & educational videos & webinars.


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