Tuesday, November 13, 2018

Small Business Blog: LLC Taxation FAQs

Many first-time business owners confuse business entities from their tax classifications. And for good reason. In this article, we will give an overview of the difference between a business entity such as an LLC versus its tax classification. Remember that for tax questions, you should always seek out the advice of a tax professional, and the information here should not be construed as advice specific to your situation.

The IRS and individual states determine how they will tax an LLC. An LLC may be taxed in four different ways: as a disregarded entity, a partnership, an S Corporation, or a C Corporation. Herein lies the first level of confusion. Among the four options, there is no such thing as an “LLC” tax classification. LLC owners are taxed as one of the four options listed above, not as an LLC. For example, a business could be an “LLC taxed as a partnership” or an “LLC taxed as an S Corporation.” But not an “LLC taxed as an LLC.” The most common approach is to be an “LLC taxed as a disregarded entity.”

The “disregarded entity” tax treatment is specific to sole proprietors and single-member LLCs. This classification allows LLCs and sole proprietors to “pass-through” their profits and losses onto their personal income tax returns. This lowers administrative burdens. Instead of filing two or more tax returns, the LLC member may file a single personal income tax return.

An LLC with more than one member can choose to be treated as a partnership for tax purposes. Like the “disregarded entity” status, partnerships are also a “pass-through” entity for tax purposes. The profits and losses of each partner are reported on each of the partners’ personal income tax returns.

LLCs taxed as a C Corporation, on the other hand, must file a separate tax return, usually on Form 1020. C Corporations are subject to “double taxation,” which means that (1) income earned is taxed, and (2) income distributed is also taxed. Many small businesses prefer to avoid the double taxation that comes part and parcel with the C Corporation. However, startup companies seeking to raise capital may have no choice other than to be taxed as a C corporation if that is what investors require.

LLCs taxed as an S Corporation must also file a separate tax return at the entity level. However, its profits and losses also “pass-through” to its shareholders. This means that the profits and losses are only taxed once at the personal income tax bracket rather than twice as in a C Corporation.

Whether you are taxed as a disregarded entity, a partnership, an S Corporation, or a C Corporation, your LLC business entity never changes. If you would like to change your business entity, you must take proactive steps to convert, dissolve, or merge your business (with some exceptions). While the business is an LLC, however, you can change its tax classification. In fact, the LLC may have more than one tax classification.

Many business owners are surprised to know that their LLC tax treatment may be different at the federal level and the state and local levels. The LLC could be taxed in two (or more) different ways. For example, your business may be an LLC based in New York City that is taxed as an S Corporation. At the federal and state level, it would be taxed as an S Corporation. However, New York City does not recognize the S Corporation election, and so in New York City, the business would be taxed as a C Corporation at the local level.

Tax classifications can be changed by filing a Form 8832, the Entity Classification Election Form, with the IRS. There are tax consequences and limitations in changing your tax status about which you should speak with a tax professional. Changing your tax status, however, does not necessitate changing your business entity. Before changing a business entity, speak with an attorney.

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