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Tax classifications for LLCs: Guide to LLC taxes

Are you an entrepreneur thinking of starting an LLC? Here’s everything you need to know about tax classifications for LLC before launching your new business.

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One of the most important decisions new business owners will make, regardless of the type of business they plan on launching, is choosing their business structure. From sole proprietorship, partnerships to C Corporations, S Corporations, and limited liability companies, the options are endless. Not only does choosing a business structure determine how small business owners will operate, but it also influences how they will file their tax return with the IRS each year, and whether they qualify for any tax benefits. 

Today, we are going to go over the tax classifications for LLC and other business structures. Therefore, keep reading to learn more information. 

What taxes does an LLC pay?

Whether you like it or not, every individual and business operating in the United States is required to pay taxes. And like we said, an important decision small business owners will need to make is to determine what type of business structure they want to operate under as it directly affects how you will file your income tax each year. If you have decided to opt for a limited liability company, then there are some options available to you. Essentially, your LLC tax classification will depend on the number of owners your business has and can be responsible for paying local tax, state tax, and federal income tax. Let’s take a closer look at this below. 

Sole proprietorship

Entrepreneurs are able to file to operate as an LLC for the purpose of gaining liability protection. This means that as a single-member LLC, your personal assets are protected should your business go bankrupt or be sued in a legal lawsuit. However, because you are still operating as a single-member LLC, the IRS will consider you a sole proprietor. Therefore, while you still have liability protection and are considered separate from your business entity you still have to report your LLC’s profits and losses, but you yourself, only have to file for personal income tax. 


With that being said, your personal tax return may look a little different depending on the business you run. As such, you may have to file tax forms such as the following: 

  1. Schedule SE for self-employment tax. 
  2. Schedule C for your business income. 
  3. Schedule E if your LLC collects income from a rental property or any investments.

Partnership

Furthermore, if you own an LLC with a number of members the IRS will consider you as a partnership for tax purposes. Therefore, as a multi-member LLC, each individual will pay tax on their share of profits on their personal income tax return. Distributions of profits between each member will be based on an operating agreement you and your co-owners decide on beforehand. 

Moreover, although LLCs that are co-owned do not file an LLC tax, you will still need to file form 1605. This IRS form is essentially an informational return that all partnerships must file. The purpose of this form is to ensure that all members of the LLC are being truthful on their income tax return and are filing their tax return correctly. 

At the same time, co-owners to an LLC must also file a schedule k-1. This form provides each member with a detailed outline of their shares, including the losses and profits made. This information is then included in their 1040 form which reports the losses and profits of your LLC to the IRS when you file your personal income tax return. 

C Corporation

On the other hand, entrepreneurs can also elect to have their LLC structured as a C Corp. This essentially means that your LLC will be subject to corporate tax as your business will be a separate business entity separate from its owners. In other words, your personal assets and the businesses assets are separate. A benefit to this is that you can qualify for tax deductions.

However, there are some disadvantages to choosing a C Corporation tax status –namely, double taxation. This means that owners will be required to file a personal tax return along with a business tax return for your corporate income. 

S Corporation

Alternatively, you may also choose to classify your LLC as an S Corporation. As a result, your LLC will not need to pay any federal taxes on profits made. Instead, the S Corporation owner will report any losses or profits made on their personal tax return. Thus, avoiding the double taxation of a C Corporation. To do so, you will need an IRS form 1120-S along with a schedule k-1 form. 

Furthermore, all LLCs have what is known as a default classification. This means that you LLC will automatically be a disregarded entity or a partnership, depending on how many members you are in business with. If you are operating by yourself as a single owner, you will automatically be classified as a disregarded entity while LLCs with more than one owner will be automatically classified as a partnership unless you opt for an entity classification election to become a c or S Corporation. 

Lastly, while not all LLCs will pay tax in the same manner, they can pay similar business tax. This includes: 

  • Payroll tax for employees
  • Self-employment tax
  • Sale tax
  • Corporate tax
  • Federal tax 
  • State tax

How to choose a tax classification for your LLC

Generally speaking, if you are a single member LLC owner, then opting for a sole proprietorship is in your favor as there is no extra paperwork you need to file as you will be automatically defaulted to this classification. In addition, as you will get all of the profits made from your business and make any decisions about your business on your own, filing one personal income tax return is most likely easiest. However, keep in mind that you will not receive any tax benefits for this classification. 

On the other hand, if you are planning to have multiple owners for your LLC, it may be best to consult with a tax professional and seek legal advice to find the best option for you and your partners. This is because taxing can become more complicated when there are more interests involved in the matter beyond your own. By doing so, you can ensure that all profits are divided to a pre agreement, while working on an operating structure that works for everyone. 

Final thoughts

As you can see, there are numerous advantages and disadvantages to each tax classification available for LLCs. Therefore, the best way to choose one for your businesses is to weigh the pros and cons for each, while taking into account the type of business you plan on launching. Once you have decided, you will need to file your employee identification number which is similar to a social security number. This allows the IRS to identify your business for tax purposes each year. 

Frequently asked questions

Do you have further questions about which LLC tax classification you should choose for your business? Take a look through some of the most frequently asked questions we get asked for more information. 

What is the best tax classification for an LLC?

Having difficulties choosing the best tax classification for your newly established LLC? Here is a closer look at the benefits and disadvantages of each. 

Sole proprietor benefits:

  • Simple tax filing process.

Sole proprietor disadvantages:

  • You will be taxed for any money that is considered leftover in your businesses. 
  • No tax benefits for this. 

Partnership benefits: 

  • Simple tax filing process.

Partnership disadvantages: 

  • Not a good choice for those who are passive owners in a business or for those who are an investor in the LLC. 

S Corporation benefits: 

  • You can avoid being double taxed.
  • You will also be eligible for tax benefits depending on the state you operate out of.

S Corporation disadvantages: 

  • Not the best option for those who are passive owners in a business or for those who are an investor in the LLC. 

C Corporation benefits 

  • Favorable for investors

C Corporation disadvantages:

  • You will be subject to double taxation.

What is the tax classification for a single-member LLC?

The tax classification for an LLC with a single member will automatically default to what is known as a disregarded entity or sole proprietorship. This means that while your personal assets and business are separate entities for liability purposes, you would only be required to file a personal income tax return with the IRS. 

What is the tax classification for a multi-member LLC?

The tax classification for an LLC that has multiple members has a couple of options. If you do not opt to classify your business as anything else, the IRS will automatically determine your business a partnership for the purpose of taxation if there are multiple members. With this classification, each owner is required to pay tax on their share of profits through the personal income tax return. Profit distribution is often determined beforehand through an operating agreement. 

Although business owners are not required to file taxes under their business, they will need to file a form 1605. This form shows that all members of the LLC are being truthful on their income tax return and are filing their tax return correctly. In addition, owners will need to file a schedule k-1 that indicates the losses and profits of your LLC for that tax year. 

Furthermore, you can also choose to have their LLC structured as a C Corp. This ultimately means that your LLC will be subject to corporate tax. This is because your business will be a separate business entity separate from its owners. As such, your personal assets and business assets are considered separate from one another. By filing as a C Corporation, business owners can benefit from tax deductions, depending on what state they operate out of. However, a disadvantage to this classification is that you will be subject to double taxation. 

The last tax classification a multi-member LLC can opt for is a S Corporation. With this tax classification, your LLC will be subject to a corporate tax rate. Because of this, your LLC will not need to pay any federal taxes on profits made. Your business will, however, need to report losses and profits made on their personal tax return. Nevertheless, you can avoid double taxation in the process. 

What is the tax classification for an individual?

Individuals who work for themselves as a small business owner will be taxed as a sole proprietorship. This means that you will file self-employment taxes and your personal taxes with the IRS together, rather than separately. 

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