Aspiring business owners have many options when it comes to legally structuring a new company. Many new business owners opt to structure their enterprises as Limited Liability Companies (LLCs), as this structure offers flexibility and protection for the personal assets of owners (called members).
One significant advantage of an LLC structure is the variety of tax options available to its members. Understanding these options can help aspiring business owners – whether they opt to form LLCs or alternative structures – make informed decisions that will broadly serve their financial and operational goals.
Default tax classification
By default, the IRS classifies LLCs as pass-through entities for federal tax purposes. This means that an LLC isn’t treated as a distinct legal entity for purposes of taxation. Instead, profits and losses “pass through” to an LLC’s members, who report them on their personal tax returns. The specific default classification depends on the number of members:
- Single-Member LLC: Treated as a disregarded entity, similar to a sole proprietorship. The owner reports income and expenses on Schedule C of their personal Form 1040.
- Multi-Member LLC: Treated as a partnership. The LLC files Form 1065, and each member receives a Schedule K-1, detailing their share of the LLC’s income, deductions and credits to report on their personal tax returns.
Election to be taxed as a corporation
Alternatively, LLC members can choose to be taxed as a corporation. This election can be advantageous for various reasons, including potential tax savings and reinvestment opportunities.
- C Corporation (C-Corp): An LLC can elect to be taxed as a C-Corp, which means the business itself pays corporate income taxes. Profits are taxed at the corporate rate, and any dividends distributed to members are taxed again at the individual level (double taxation).
- S Corporation (S-Corp): An S-Corp tax election results in pass-through taxation, similar to a default LLC classification, but with some additional benefits. For example, there are ways for S-Corp members to potentially save on self-employment taxes.
How LLCs are taxed is just one consideration that a new business owner must make when structuring their company. Seeking legal guidance can help business owners to take in the “bigger picture” before committing to an approach.