This could be the most important article you read on the web regarding the choice of your tax status as an LLC. So many mistakes are made in this area and as a result, the formation of the LLC is hindered from the start. Back when LLC’s were first written into law, it was the intention of our lawmakers to create an entity that provided limited liability protection, and the freedom to choose a tax status that would suit the LLC’s business model. However, shortly into the use of the new legal entity did many LLC providers (lawyers, law firms, etc) realize that many business owners needed to talk to a qualified tax professional to choose the right tax status. Of course, Lawyers didn’t want the hassle of providing this as part of the LLC service. As a result, many business owners would visit their tax professionals the following year to do their taxes and were penalized for not having made the appropriate elections to avoid the large tax pitfalls.
The tax designation of your LLC is an important decision and should be made with careful consideration. The determining factor of which tax status you should ultimately be depends on your goals and preferences as an owner.
The first thing to consider is how many owners your LLC has. Are you a single member or multi-member LLC? For instance, a multi-member LLC may want to have various levels of ownership in the LLC; a majority owner and a minority owner. The majority owner is the person who operates the business full time and makes many of the crucial decisions that drive the direction of operations. The minority owner is simply using their capital to help fund the operations of the business. In this example, the LLC should form a partnership or a C-Corp. These entities allow for different kinds of ownership within the LLC under the Internal Revenue Code.
If you’re a single-member LLC it is less complicated and really narrows the decision down to personal preference. For instance, a single-member LLC can forgo making a federal election to be a C-Corp or S-Corp and as a result, would report all of the earnings on a Schedule C of Form 1040. This creates less paperwork and less hassle for the business owner from a reporting perspective. However, this also creates the greatest tax impact on the owner both short and long-term. Single Member LLC’s are subject to both federal income tax and self-employment tax. Potentially doubling the amount of tax paid on the earnings within the business.
If you are a single member or multi-member LLC, you may want to consider the benefits of being an S-Corp. By far the S Corp has become the most popular tax designation in recent years. As an S-Corp, you are limited to one kind of ownership(one class of stock). However, you avoid the heavy tax burden that comes with being a sole proprietor or partnership. You can take distributions from the business tax-free (unlike the 15% dividends tax on C-Corps) and you can take a wage as an owner, limiting your exposure to Self-Employment taxes to whatever that wage is. Experts agree for a simple ownership structure and as a low tax cost alternative, an S-Corp meets the needs of most general business models.
Below are the recommendations for what you should choose as your tax designation for your LLC. Within each recommendation are the preferences that you should decide on whether they describe your present needs.
Sole Proprietorship (Single-Member LLC ONLY):
- There is only a single owner.
- Adequate liability insurance is available at an acceptable cost, or the majority of liability exposure is from the owner’s practice of a profession.
- Minimized administrative expenses and paperwork is a major objective.
- You as the owner do not currently wish to deal with the issue of how future transfers of ownership interest will be accomplished.
- You as the owner do not currently wish to deal with the issue of how additional equity capital might be raised.
- The newly acquired business is currently small enough that operating as a sole proprietorship is still a rational choice in light of the above considerations.
S-Corporation (Single Member or Multi-Member LLC):
- You have a major concern about, and want to limit your exposure to, business-related liabilities that are not covered by insurance.
- You want the advantage of pass-through taxation and the opportunity to minimize Self-Employment taxes (additional 15.4% tax on top of your federal income tax rate).
- The S Corporation restrictions are not a major concern when you consider future plans to add new owners or transfer ownership interests to others for estate planning, family tax planning, or business succession planning purposes.
- You need to make sure that state laws in your state don’t prohibit certain professions from operating as an S-Corp that is a single-member or multi-member LLC.
C-Corporation (Single Member or Multi-Member LLC):
- Your business is going to be capital intensive to fund rapid expansion, and as a result, you need all the earnings to stay within the business.
- A major concern is acquiring capital to maintain operations within the business both short and long term.
- You are aware of the double taxation incurred as a result of operating as a C-Corp. Federal income tax on all earnings and a dividends tax on all distributions. However, the flat 21% tax is preferred to the higher taxes that can be experienced when earnings pass through to the shareholder/partner of an S-Corp or Partnership.
Partnership (Multi-Member LLC ONLY):
- There will be more than one owner.
- Pass-through taxation is desired.
- The advantages of partnership taxation are significant compared to the alternative of S-Corp taxation or the entity cannot qualify for S Corporation status.
- The activity can be operated as an LLC under state law and applicable professional standards.
- You desire to have the flexibility of creative ownership, having limited partners in the partnership that are simply there for funding and not maintaining operations.
Hopefully, after reading this article you have a greater insight towards making the decision of what your tax status should be for your new LLC. A few key takeaways below:
- A Single Member LLC that doesn’t make a federal election, defaults to a Sole Proprietorship which files everything on a Schedule C of Form 1040
- A Multi-Member LLC that doesn’t make a federal election default to a Partnership which files everything on a Form 1065 US Return of Partnership.
- You have 75 days to elect to be a C-Corp or S-Corp from the date your LLC becomes effective. Late elections can be made, but sometimes are not approved by the IRS without proper citation of the reasons for a late election.
Always seek the guidance of a qualified tax professional. This article is not meant to serve as tax advice or guidance. The key points in this article should only be used for educational purposes. SIMPLE START LLC doesn’t take responsibility for poorly informed decisions that may have resulted from the use of the information in this article. We want you to make informed decisions and encourage the use of our services to start your new LLC today.
Please see some of our other blog posts that provide additional insight into the tax status designation, examples of business models, and how to structure an LLC that services your needs into the future.