Deciding on the most advantageous way to tax your new limited liability company (LLC) is an important step in establishing a solid foundation for your business. This decision can significantly impact your financial health, influencing everything from your take-home pay to your tax obligations and your ability to attract investors.
An LLC is a flexible business structure, offering the legal protections of a corporation with the tax efficiencies and operational flexibility of a partnership. By default, the Internal Revenue Service (IRS) does not recognize an LLC as a separate tax entity, so the business itself is not taxed. Instead, taxes are generally paid through the individual members’ tax returns. However, LLCs have the unique ability to elect how they are taxed, choosing between being treated as a sole proprietorship, partnership or corporation for taxation purposes.
Weighing your options
If your LLC has a single member, so by default, it is taxed as a sole proprietorship. Income will pass through to the member’s personal tax return, simplifying the tax filing process but subjecting personal assets to potential liability. For multi-member LLCs, the default taxation is as a partnership, where income and losses pass through to members according to their ownership percentages.
Electing to be taxed as an S corporation can be beneficial for LLCs that meet IRS requirements. This option allows profits (and losses) to pass through to owners’ personal tax returns, avoiding double taxation. It also enables members to be treated as employees, potentially saving on self-employment taxes.
Alternatively, opting for C corporation taxation means that a LLC is taxed separately from its owners, introducing a layer of complexity with potentially double taxation (first on the company’s income and again on dividends to shareholders). This structure can be advantageous for businesses planning to reinvest profits into the company or seeking venture capital.
The choice of tax classification for your LLC involves several considerations. These should be contemplated carefully in order to better facilitate the success of your company down the line.
