The Basic Guide to LLC Tax Classification

Business Basics

What’s the best part about starting a new business? Choosing a business name, designing your website, having those fancy, super-thick business cards printed…these are all VERY exciting aspects of becoming your own boss.

Not so exciting? Choosing a tax classification.

Who has time to think about the IRS when you’re busy coaching eager clients, providing actual value to the world?

But, as it turns out, your new business’s tax classification can have a huge impact on your tax liability.

So what are your options? Read on to find out!

How to Cover Your (Business) Assets

As a business owner, you will most likely identify your company as a Sole Proprietorship or as an LLC.

How are they different?

Sole Proprietorship: You And Your Business Are One In The Same

This is the most basic business structure. It is an unincorporated business run by a single person. There’s no legal distinction between you as the owner, and you as a business. Your business income is reported on your personal tax return, and you are legally liable for the debts of your company.

LLC (Limited Liability Company): You and Your Business Are Legally Separate

Think of an LLC as a “shell” that insulates your personal property against lawsuits. This shell, created at the state level, can be federally taxed in several different ways based on how you choose to structure your company. An LLC can be owned by one or more individuals.

The Key Difference

The key difference between a sole proprietorship and an LLC is liability. LLC owners are not personally liable for the business, so if your company is sued, an LLC protects your personal assets, like your home, from being seized.

To avoid personal risk, an LLC is generally a better choice. An LLC will protect your personal assets if a lawsuit is filed against your business. A Sole Proprietorship offers no such protection. If you are sued as a Sole Proprietor, your personal assets could be seized in a court ruling. Yikes!

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Choosing Your Tax Classification

The IRS doesn’t really care about your LLC–they care about your LLC’s tax classification. This is what determines how your business income is viewed (and taxed) by the IRS.

The good news is that you can choose how your LLC will be taxed. This freedom of choice allows you to make the best financial choice for your business.

Once you’ve formed your LLC, you can choose your tax classification from 3 options:

  • C-Corp
  • Default
  • S-Corp

LLC Tax Classifications

C-Corp

A C-Corp is a legal business structure in which business income is taxed, dividends are paid out to shareholders, and the shareholders are then taxed on their income too. This is known as “double taxation,” and it’s not small-business friendly. Since the majority of my clients are coaches and consultants who work for themselves, we’ll just leave C-Corp at its basic definition.

Most small businesses will choose between the Default and S-Corp tax classifications.

Default

Most LLCs fall into this category. By default, the IRS classifies the LLC according to its number of members. A Single-Member LLC is considered a “disregarded entity,” which simply means the IRS pretends the company doesn’t exist for simplicity’s sake, and records business income on the company owner’s personal tax return.

A Multiple-Member LLC, or Partnership, is taxed like a Single-Member LLC, except the tax liability is split according to ownership percentages in the company.

PROS: easy to form, simpler and cheaper filing, no restrictions on number of members or partners

CONS: owner must pay self-employment taxes, which includes employee and employer shares of Medicaid and social security

S-Corp

If you don’t want to stay as your default classification, you can elect to change your company’s filing status to an S-Corp. S-Corp status is extremely popular with small businesses because it allows profits to flow through to company shareholders, who then report their share of company income on their personal tax return. This avoids double taxation.

PROS: no double taxation, income isn’t subject to self employment tax, allows shareholders to set a reasonable salary that is taxed (as opposed to total business income), shareholders can receive dividends after salary is paid

CONS: more complex filing process, rules are different according to state, electing S-Corp status is complex and usually requires professional assistance

It Depends on Your Unique Business

Ultimately, your unique business needs will determine which classification you choose. If in doubt, it’s smart to discuss your financial strategy with a business coach, tax pro, or other knowledgeable person who can guide you in your decision. After all, your tax classification determines how much you’ll owe the IRS, something any savvy business owner should understand!

Let’s work together

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