When considering how to structure a new business, people sometimes ask about the tax benefits of a limited liability company and an S corporation. While there are similarities in the way these two entities are taxed, an LLC offers more options.
How a Corporation Is Taxed
To understand taxation of an LLC, it is necessary to know how corporations are taxed. When a corporation is first formed, it is considered by the Internal Revenue Service (IRS) to be a C corporation. A C corp. must file a U.S. Corporation Income Tax Return (Form 1120) and pay corporate income tax on its profit.
If any of the profits are distributed to shareholders as dividends, each shareholder must report the dividend on his individual tax return, using U.S. Individual Income Tax Return (Form 1040) and Profit or Loss From Business (Schedule C), and pay tax on the dividend.
By filing a form with the IRS, a corporation can choose to be taxed as an S corporation. If a corporation has elected S corp. status, it must report the profit on U.S. Income Tax Return for an S Corporation (Form 1120S), but the corporation itself does not pay any tax. Instead, any corporate profit is attributed directly to the shareholders, in proportion to the number of shares held. Each shareholder reports his share of the profit on his individual tax return, using Form 1040 and Schedule K-1 (Form 1120S), and pays tax on that amount. The shareholder must pay the tax even if the corporation does not actually pay him a dividend.
How an LLC Is Taxed
To some extent, how an LLC is taxed depends on its ownership. An LLC that has only one owner, or member, is called a single-member LLC, while an LLC with two or more members is known as a multiple-member LLC.
Taxation of a Single-Member LLC
When a single-member LLC is first formed, it is considered by the IRS to be “an entity disregarded as separate from its owner," which means it is taxed like a sole proprietorship. Any profit from the business is reported by the member on his individual tax return, using Form 1040 and Schedule C.
By filing a form with the IRS, a single-member LLC can choose to be taxed as either an S corp. or a C corp. This results in filing the same forms as indicated above for corporations. Being taxed as a sole proprietorship requires fewer forms.
Taxation of a Multiple-Member LLC
A multiple-member LLC is initially treated by the IRS as a partnership. The LLC itself does not pay tax, but it does file a U.S. Return of Partnership Income (Form 1065) showing how profits were allocated among the members. Each member reports his share of the profit on his individual tax return, using Form 1040 and Supplemental Income and Loss (Schedule E).
By filing a form with the IRS, a multiple-member LLC can choose to be taxed as an S corp. or a C corp. Such an election results in filing the same forms as indicated above for corporations.
Effect on State Taxes and Fees
S corporation status of both corporations and LLCs is generally recognized for state income tax purposes. However, this does not have any effect on various other types of state business taxes, such as sales, use, excise, commerce, and franchise taxes; and other fees such as business license, registration, and annual reporting fees.
Regarding federal taxes, there is no difference in the manner of taxation between an S corporation and an LLC that chooses to be taxed as an S corporation. Between these types of entities and an LLC that does not elect S corporation status, the primary difference is in the specific forms that must be filed with the IRS. The manner of taxation you choose depends upon several factors, including the amount of expected profits, whether profits will be distributed to owners or retained by the business, whether you have employees, the benefits offered to employees and owners, and state will taxes.