Because the Internal Revenue Service (IRS) does not have a separate tax classification for LLCs, it is not a matter of evaluating the tax benefits of an LLC vs. a sole proprietorship or an LLC vs. a corporation. The real tax benefit of an LLC is that it allows the business to choose how it will be taxed, thus giving the business the most options.
Main Tax Concerns of an LLC
The two main tax issues regarding an LLC are whether any taxes are imposed on the business itself and how taxes are imposed on the owners, who are called members. There are four ways for an LLC to be classified for tax purposes:
- Sole Proprietorship. The IRS refers to this type of business structure as "an entity disregarded as separate from its owner." The term applies only to a single-member LLC, which is an LLC with only one member. In this scenario, the income and expenses of the LLC are the income and expenses of the owner, who would be subject to self-employment tax. All single-member LLCs start out in this category but can convert to being taxed as either C corporations or S corporations.
- Partnership. This only applies to a multiple-member LLC, which is an LLC with two or more members. The LLC itself is not taxed, but its profits are taxed to the members. All multiple-member LLCs start out in this category but can convert to being taxed as either C corporations or S corporations.
- C Corporation. To choose this option, file an Entity Classification Election (Form 8832). An LLC taxed as a C corporation pays a corporate tax on its profits. Any profits distributed to members are then taxed to the members. This is known as double taxation.
- S Corporation. To select this option, file an Election by a Small Business Corporation (Form 2553). An LLC taxed as an S corporation is not taxed on its profits, but the profits are taxed to the individual members, even if the profits are not actually distributed to the members.
In other words, every LLC is taxed as if it were some other form of business. A single-member LLC has three options: sole proprietorship, C corporation, or S corporation. A multiple-member LLC also has three options: partnership, C corporation, or S corporation. For more information about LLC taxation, see the IRS publication Taxation of Limited Liability Companies (Pub 3402).
Choosing how your LLC will be taxed requires consideration of a number of factors, including the amount of anticipated profits, whether profits are distributed to the member or retained by the business, whether you have employees, the fringe benefits offered to employees and members, and how your state taxes the entity.
Filing Process by Type of Entity
When choosing how your LLC will be taxed, you may want to be aware of the tax-filing process, as some entities have more complex processes than others:
- Sole proprietorship. This option simplifies the tax-filing process. You report the profit or loss on your personal tax return, U.S. Individual Income Tax Return (Form 1040), along with a Profit or Loss From Business (Sole Proprietorship) (Form 1040, Schedule C). For some businesses, instead of Schedule C, you would file a Supplemental Income or Loss (Form 1040, Schedule E) or a Profit or Loss From Farming (Form 1040, Schedule F).
- Partnership. The LLC files a U.S. Return of Partnership Income (Form 1065), showing each member's share of the profit or loss. Each member then reports his share on Form 1040, along with a Partner's Share of Income, Deductions, Credits, etc. (Form 1065, Schedule K-1).
- C Corporation. The LLC files a U.S. Corporation Income Tax Return (Form 1120) and pays a corporate tax on any profits. If any of the profits are passed on to the members, each member reports his share on Form 1040, along with an Interest and Ordinary Dividends (Form 1040A or 1040, Schedule B). Having an LLC taxed as a C corporation is often done when profits are retained by the LLC rather than distributed to members.
- S Corporation. The LLC files a U.S. Income Tax Return for an S Corporation (Form 1120S). Each member reports his share of the profits on Form 1040, along with a Shareholder's Share of Income, Deductions, Credits, etc. (Form 1120S, Schedule K-1). The main reason LLCs choose an S corporation over a C corporation is to avoid double taxation.
Business Tax Deductions for an LLC
Regardless of the tax treatment chosen, the business can take advantage of tax-deductible LLC expenses. However, with respect to the LLC deducting certain employee benefits provided to members, such as medical, disability, and life insurance, it may be advantageous to select C corporation status. Otherwise, these types of benefits may become taxable to the members.
For most small business owners, structuring a business as an LLC offers the most versatility in determining how the business is taxed, while also offering the limited liability of a corporation but with less formality. If you still have questions, you may wish to work with an online service provider for guidance.