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:
LLC Tax Classifications
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.
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
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!