Attorney Explains LLC Tax Classifications: Sole Proprietorship, Partnership, S Corp, & C Corp
If you're considering starting a business in California, a key decision you'll need to make is how to structure your company. One popular option is to form a Limited Liability Company – an LLC. Aside from the benefit of limited personal liability protection, something we’ll discuss in depth in our next post, LLCs provide their owners (known as "members") with the ability to choose how they want to be taxed. If you can’t escape taxes, you may as well pick how you’ll be taxed anyway. Below, we'll explore the various tax classifications available for an LLC and what they mean.
What are the Tax Classifications for an LLC?
As discussed, getting to pick the tax classification, as in how you want to be taxed, is a key benefit of forming an LLC. You create a separate legal entity that can do things separately from your personal dealings yet also pick how that entity is going to be taxed. An LLC can be taxed in several ways, depending on how it’s structured and the number of owners, or members, it has. We’ll briefly list them first before discussing each in depth so feel free to use the section headers to jump to the section you want to learn more about.
The different tax classifications are:
Sole Proprietorship: If an LLC has only one owner, it can be taxed as a sole proprietorship. The business income is reported on the owner's personal tax return. This is the default tax classification for a single member LLC unless the owner files for a different classification with the IRS.
Partnership: If an LLC has two or more owners, it can be taxed as a partnership. The business income is divided among the owners and reported on their individual tax returns. This is the default tax classification for a multiple member LLC unless the owners file for a different classification, again, with the IRS.
S Corporation: An LLC can choose to be taxed as an S Corporation by filing an election with the IRS. This allows the business to avoid double taxation and provides the owners with the benefits of a corporation.
C Corporation: An LLC can also choose to be taxed as a C Corporation, which is a separate taxable entity. This structure is typically used by larger businesses and can result in double taxation of the company's income – taxes at the corporate level and taxes at the owner level.
Read more: Land Trust vs LLC | When to Use One Over the Other
LLC Taxed Like a Sole Proprietorship
When an LLC is taxed as a sole proprietorship, it means that the business is considered a single entity for tax purposes, but its income is reported on the owner's personal tax return (Form 1040, Schedule C). In this case, the LLC does not file a separate tax return and there is no distinction between the business and its owner for tax purposes.
This tax classification is only available for single-member LLCs, as it is essentially a default classification for these types of businesses. The owner of a single-member LLC reports their business income on their personal tax return and is responsible for paying taxes on that income at their personal tax rate. In general, being taxed as a sole proprietorship can simplify the tax process for a single-member LLC, as it does not require the preparation of a separate tax return for the business.
LLC Taxed Like a Partnership
When an LLC is taxed as a partnership, it means the business is considered a separate entity for tax purposes, but it does not pay taxes on its income. Instead, the profits and losses of the business are divided among the owners (also known as partners) and reported on their individual tax returns. Sole proprietorships, all profit and loss to the one owner. Partnerships, profits and losses are reported similarly, but spread out equally among all the owners.
Partnership classification is the default for multi-member LLCs, unless the owners file for a different classification. In this structure, each owner is responsible for paying taxes on their share of the business income at their personal tax rate. The business itself does not pay taxes on its income, but it must file an informational tax return (Form 1065) to report the income, deductions, and credits of the business.
In general, being taxed as a partnership allows for the owners to enjoy the benefits of a separate legal entity for the business, while still taking advantage of the pass-through taxation system, where the business income is only taxed once at the individual owner level.
LLC Taxed Like an S-Corporation
An LLC can choose to be taxed as either an S Corporation or a C Corporation, rather than as a sole proprietorship or a partnership. This choice is made by filing an election with the IRS, this time using Form 2553.
An LLC taxed as an S-Corp is considered a separate entity for tax purposes and it does not pay taxes on its income. Instead, the profits and losses of the business are divided among the owners and reported on their individual tax returns, similar to a partnership, however, each owner is only responsible for their proportional interest in the company. They receive a Schedule K-1 form that reports their share of the business's profits, losses, deductions, and credits. The owners then report this information on their personal tax returns (Form 1040) and pay taxes on their share of the business income at their personal tax rate.
The key benefit is that an S-Corp election offers the owners the benefits of a corporation, including limited liability protection and the ability to issue stock. Here, the owners are considered shareholders and are only taxed on the income they receive from the business. This helps to avoid double taxation, which is a common issue with C-Corps.
LLC Taxed Like a C-Corp
An LLC taxed as a C-Corp is considered a separate taxable entity, distinct from its owners. The business pays taxes on its income, and the owners pay taxes on any income they receive from the business, such as salaries, dividends, or capital gains. This results in the possibility of double taxation, as the business income is taxed at both the corporate and individual level.
C Corporations are typically larger businesses and are subject to more complex tax rules and regulations than S Corporations or partnerships, and typically the type of business you’ll find on an exchange like the NASDAQ or New York Stock Exchange.
Does the Tax Classification Affect Personal Liability Protection?
Another point to keep in mind is what impact the tax classification election has on the personal liability protection in LLCs. The election for an LLC does not directly affect the personal liability protection for its members. Whether an LLC is taxed as a sole proprietorship, partnership, S-Corp, or C-Corp, the personal liability protection for its members remains the same, meaning that their personal assets are generally protected from creditors and other claimants.
Of course, it's important to consult with an attorney or tax professional to determine the best tax classification for your LLC, considering your specific business goals and financial circumstances.
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