LLC Tax Status Options
An LLC (Limited Liability Company) is an attractive business form. It offers the limited liability of a corporation and flexible taxation, though by default an LLC is taxed as a partnership. Harvard Business Services, Inc. has made the process simple and convenient. To file and form both an LLC and a Certificate of Formation requires little to no personal information. Because of this, very little is publicly available. Not surprisingly, the LLC is the most popular type of Delaware business entity, accounting for almost 75% of our new formations.
Once the formation of the LLC is established with the State of Delaware, the next step is to obtain the LLC’s employer identification number (or “EIN”). An EIN is like an LLC’s social security number. To apply for the EIN, the responsible party states the number of LLC members; the number of members determines the LLC’s tax status under the Internal Revenue Code of 1986.
For LLC tax purposes, the IRS considers a single-member LLC a disregarded entity, and a multi-member LLC is considered a partnership. A Single member or Multimember LLC is taxed on a pass-through basis. The LLC itself is not taxed traditionally on the federal level, the profits and losses flow through to the LLC members’ share of the entity’s profits and losses.
Disregarded Entity. A disregarded entity is entirely disregarded for tax purposes, as if it did not exist. A single member LLC is a disregarded entity from the outset, and the individual member is taxed as if they experienced the gain or loss directly. If the LLC has more than one member, it is treated as a multi-member partnership for tax purposes, unless it elects otherwise.
Partnership Tax. An LLC with more than one member is taxed by default as a partnership under Subchapter K of the IRS Code. Partnership taxation is pass-through taxation. The net income or loss of the partnership (or LLC) is taken onto the taxes of the individual members according to their allocated share of such gain or loss, with the character of the income passing through as well (e.g., long term capital gains, ordinary income, etc.).
If neither of the two initial tax statuses (available to the LLC when the EIN is obtained) does suit the taxation requirements of the entity, there are other options available. For instance:
S-Corp Election – A Different Kind of Pass-Through. An LLC can elect to be taxed as a corporation that has, in turn, elected to be taxed on a pass-through basis under Subchapter S of the Code. The S-Corp Election provides minor, but important, variations on partnership pass-through treatment, such that there is in fact a viable choice between one type of pass-through taxation and another. As with partnership taxation, taxes are passed through to members and reported on the members’ own taxes. However, there are reasons that a company would elect Subchapter S status, depending on the circumstances.
S-Corp status for the LLC does have some additional benefits over partnership taxation. For instance, founders will only pay FICA self-employment tax on amounts the founders pay themselves as salary, but not on the entirety of distributions, as would be the case with a partnership. Further, an S-Corp may seek to claim the 20% “qualified business income” deduction, available in some cases. This deduction allows eligible self-employed and small-business owners to deduct up to 20% of their qualified business income on their taxes.
Of note, there are restrictions required to elect Subchapter S. For example, a company making an S election:
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Must be a U.S. entity,
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May not have non-U.S. members,
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May not create more than one class of investment,
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May only have natural person members,
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May not have more than 100 beneficial owners
Changing an LLC’s tax status is relatively simple: the LLC must file an IRS Form 2553 and both initially and on an ongoing basis satisfy the requirements of S-Corp status.
C-Corp Election – Entity Taxation. An LLC may change from partnership tax status to taxation as a corporation. Under corporation taxation, provided in Subchapter C of the Code, the LLC is taxed at corporate income rates, and members pay a second tax upon receiving distributions. Because of these two layers of LLC taxes, “double taxation” as it is known, electing C-Corp status seems counterintuitive. However, given the low corporate income tax rate and the fact that many distributions will be treated as long-term capital gains, taxed at a much lower rate, such an election may make sense financially.
To change the Entity Classification Election to a C-Corp for federal tax purposes, the LLC files IRS Form 8832. With this election, the LLC pays tax on its income at corporate tax rates and Members (owners) also pay tax on distributions from the corporation.
Keep in mind that changes can always be made to how the LLC is taxed by the IRS, but such a change can have unintended or unforeseen consequences. Therefore, it is a good idea to discuss any changes to the LLC’s tax status with a tax professional familiar with business entity taxation. If changes are made to the tax classification of the LLC, Harvard Business Services, Inc. does not need to know of the change, and neither will the Delaware Division of Corporations.
Although we are not tax accountants, and do not provide tax advice, feel free to reach out to our team of friendly knowledgeable associates on the forming of your LLC and the EIN, as well as to discuss these concepts above in a general way. We are happy to assist!
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source's content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.
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There is 1 comment left for LLC Tax Status Options
Miles Fidelman said: Thursday, April 7, 2022What's the current treatment of series LLCs, particularly when our home office is in Massachusetts. Related question: Again, in MA, if we create a new series LLC, do we need to file a separate local registration, annual fee, etc. - or is that all folded under the master registration?
HBS Staff replied: Thursday, April 7, 2022Thank you for your question. One of our specialists would be happy to reach out to help answer your question.