What are the Four Ways an LLC Can Be Taxed Under the Internal Revenue Code?
Sole ProprietorshipIf the LLC has only one member or only two members who are married and who own their interest in the LLC as community property, the LLC can be taxed as a sole proprietorship. This is the IRS' default method of income tax for a single member LLC.
An LLC taxed as a sole proprietorship is treated by the IRS as if it does not exist. The IRS treats the LLC as a disregarded entity. The advantage of the sole proprietorship of federal income tax is that the LLC does not have to prepare and file a separate tax return. Everything goes on the member's IRS Form 1040, Schedule C.
PartnershipIf the LLC has two or more members, it can be taxed as a partnership. This is the IRS default method of tax for every multi-member LLC.
An LLC taxed as a partnership must prepare and file a partnership tax return. The LLC then issues each member a K-1 with the member's tax information. The members enter their K-1 information on their IRS Form 1040s.
C CorporationEvery LLC has the option to file an election with the IRS to be taxed under subchapter C of the Internal Revenue Code. This method of tax is commonly called being taxed as a "C corp" or "C corporation."
An LLC that elects to be taxed as a C corporation must prepare and file an IRS Form 1120 . Do not elect to cause your LLC to be taxed as a C corporation without first consulting with an experienced business tax lawyer or CPA because this method of taxes can result in two levels of federal income tax.
A C corp is a taxing paying entity. If it has $100 of profit at the end of the year, it must pay the federal income tax on that profit. 2010 corporate tax rates are:
15% on the first $50,000
25% on the next $25,000
34% on the next $25,000
39% on profits over $100,000 up to $335,000
The total tax on the first $100,000 of C corp profits is $22,250, which is 22.3%. This means $77,750 is left after tax to pay to the members who then pay a second tax.
S CorporationIf the LLC is eligible, the members may file an election with the IRS and cause the LLC to be taxed under subchapter S of the Internal Revenue Code. The general rule is that all of the members of the LLC must be people who are U.S. citizens.
The primary reasons LLCs elect to be taxed as an S corporation are:
1. To avoid the double tax applicable to an LLC taxed as a C corporation.
2. To reduce the amount of payroll taxes payable to the members (sometimes - whether this will apply to your LLC depends on the facts and circumstances of your LLC's situation year to year).
An LLC taxed as an S corporation is not an entity that pays tax. The LLC does file a tax return on IRS Form 11020S, but it does not pay federal income tax. The LLC's profits and losses are passed through to the members pro rata based on the percentage ownership of each member.
How to Elect the LLC's Method of Federal Income TaxThe IRS default methods of income tax for LLCs is as follows:
1. Single member LLC: sole proprietorship / disregarded entity
2. Multi-member: partnership
If your LLC wants to be taxed under the default method, it finalizes that method by filing the appropriate tax return on time.
If the LLC wants to be taxed as a C or S corporation, it must file the appropriate form with the IRS per the following:
1. An LLC that desires to be taxed as a C corporation must file an IRS Form 8832. New entities that want to be taxed as a C corporation from the date of formation must file the Form 8832 with the IRS not later than 75 days after formation.
2. An LLC that desires to be taxed as an S corporation must have all members who own an interest in the LLC sign an IRS Form 2553 and file it with the IRS not later than 75 days after formation to be taxed as an S corp from day one.
What are the Eligibilty Requirements for an LLC to Elect to be Taxed as an S Corporation?An LLC may not be taxed as an S corporation unless it meets all of the following requirements set forth in Internal Revenue Code Section 1361:
1. It may not have more than 100 members.
2. It may not have a member that is not an individual (no companies) unless the member is an estate, a trust described in Section 1361(c)(2), or an organization described in Section 1361(c)(6).
3. It may not have a member that is a nonresident alien.
4. It may not have more than one class of membership interests.