Tax Classification for LLC | Our Full Guide to Ways of Being Taxed by the IRS

Key Takeaways

• An LLC tax classification determines how the company will be taxed and what its tax obligations are.
• LLCs do not have a required tax classification. They can choose to be taxed as a sole proprietorship, partnership, C corporation, or S corporation depending on the number of members or what they agree on.
• When deciding how your LLC will be taxed, you'll need to consider how much your business makes and how much it spends on overhead costs like advertising and utilities.

1. Sole Proprietorship

A sole proprietorship is a business owned and operated by an individual. It has no legal distinction between the owner and the business itself, so the owner's personal assets are at risk if the business fails.

Many small businesses are sole proprietorships, including most self-employed people such as writers, contractors, and consultants. The biggest advantage of a sole proprietorship is that it's easy to start and operate.

Taxed as A Sole Proprietorship

The first thing to understand is that most states allow LLCs to choose how they will be taxed. The decision will have implications on how much income tax you'll owe as well as how you file your taxes.

Unlike C corporations, LLCs do not pay taxes at the entity level. Instead, they pass through all profits or losses to their owners, who record them on their personal tax returns. 

A single member LLC that does not elect out of taxation as a partnership is classified as a disregarded entity for federal income tax purposes (this means that it does not file its own separate return). Instead, all income and expenses are reported on the owner's personal tax return. This type of LLC is known as a "disregarded entity."

Single Member LLC

For example, if you are an attorney who owns a single-member LLC that provides legal services to clients, all of the income from that business is reported on Schedule C of your Form 1040.

You then deduct any business expenses from your gross income to arrive at net profit or loss. The net profit or loss is then included on line 12 of Form 1040 (or line 21 for short form).

2. Partnerships

A partnership is a business where two or more people share ownership of the business. Each owner has an ownership stake in the company and its profits and losses.

Partnerships don't pay income tax themselves; it gets passed through to the partners who then pay taxes on their share of profits at their personal income tax rate.

 Taxed as A Partnership

A multi-member LLC can also choose to be taxed as a partnership, which means it will have to file Form 1065 with the IRS. This form is used to report income and expenses for all partnerships that have two or more owners. The partnership does not pay taxes itself, but each partner reports their share of the profits and losses on their individual tax returns.

It is the Common Form of Taxation for Larger Businesses

This is the most common form of taxation for larger businesses with multiple owners.

However, this option also requires significant ongoing record-keeping and compliance obligations such as maintaining books & records to name just a few.

3. S Corporations

An S corporation is a special type of corporation created by the IRS to avoid double taxation.

Double taxation occurs when all profits are first taxed at the corporate level, then again at the shareholder level when they receive dividends from their shares in the company- in this case, the S corporation’s shareholders would be taxed twice if they were C corporations.

Taxed as an S Corporation

S corporations do not pay federal income tax; instead, it passes through their profits and losses to their shareholders, who report these amounts on their personal income tax returns (Forms 1040). However, the IRS has strict rules about who can be taxed as an S Corporation:

4. C Corporation

A corporation is an entity that is separate from its owners. Corporations are typically formed by filing articles of incorporation with the state, which sets up the corporation’s existence as a legal entity. A corporation is owned by shareholders and can be public (traded on a stock exchange) or private (not traded on an exchange).

Filing Taxes as a C Corporation

When you file taxes as a C corporation, you pay taxes on your profits at both the corporate level and at the individual level when those profits are distributed to shareholders in the form of dividends.

For example, if you have $100,000 in net income after all expenses are paid, you will pay at the corporate level, say between 15% and 35%, depending on your state), then you're left with about $80,000 in profits which will be taxed again at individual rates.

What Are the Different LLC Classifications?

There are several different classifications of LLCs you can choose from when filing your articles of organization with your state's secretary of state or equivalent agency. These include:

Single-Member LLCs

Single-member LLCs are for sole proprietorships or solo entrepreneurs who want to run their business under an LLC but don't have any partners or employees. They're often used by freelancers and consultants who want to protect their personal assets from liability.

Multi-Member LLCs

If you have more than one owner in your business, then it's classified as a multi-member LLC. You can have anywhere from two to 100 owners in your business, depending on how many owners your state allows for that particular type of entity.

Member-managed LLC. This is a business entity where all members manage the company. There are no managers, just members who are involved in the day-to-day operations of the business.

Manager-member LLC. This type of entity is similar to a member-managed LLC except that an outside manager must be hired by the members to oversee the day-to-day operations of the business. Managers can also be employees or independent contractors who receive compensation for their services as outside managers.

Domestic LLCs

A domestic limited liability company (LLC) is registered in just one state where it does business. Domestic LLCs have fewer regulations than foreign LLCs, but they must follow all state laws regarding formation, operation, dissolution, and taxation.

Foreign LLCs

A foreign limited liability company (LLC) is registered in one state but conducts business across multiple states or internationally. Foreign LLCs have more regulations than domestic ones because they operate in multiple jurisdictions across borders or oceans.

Series LLC

A series LLC is a way to group your business interests into separate and distinct entities. It allows you to have multiple businesses under one umbrella.

A series LLC can be used for various purposes, including real estate investment and holding companies. It does not have to be used for multiple businesses; it could be used by one person with different assets or even just one property.