LLC Tax Classification: Which One Is Right for You?
If you've been Googling LLC tax classification options, you're probably trying to figure out which setup will save you the most money at tax time. So, what are the most important things you need to know?
This topic can be confusing for small business owners, but an LLC is just a legal structure. It's how your state recognizes your business. Tax classification is separate, and that's what tells the IRS how to tax your income.
Grab your coffee, and let's take a closer look at the LLC tax classifications you can choose from!
What Is an LLC Tax Classification?
When you form an LLC, the IRS treats it as a disregarded entity for tax purposes.
That sounds harsh, but it just means that the agency doesn't recognize your LLC as a separate taxpayer. Instead, it taxes the owner (you) directly:
If you're the only owner, the IRS treats your LLC like a sole proprietorship by default
If there are multiple owners, it's taxed as a partnership
These classifications happen automatically unless you file paperwork to elect something different.
So, what are your options, and how do they influence which forms you file and how much you might pay in taxes?
The 4 Different Types of LLC Tax Classification
Sole Proprietorship (Single-Member LLC)
This is the default if you're the only owner of your LLC.
The IRS ignores your LLC structure and taxes you like a self-employed individual. You report your business income and expenses on Schedule C, and attach it to your personal tax return.
This is a straightforward tax classification for an LLC, but the downside is that your profits get hit with both income tax and self-employment tax, which covers Social Security and Medicare.
That self-employment tax runs 15.3% on your net earnings, and it applies to everything you make after deducting business expenses. So, you often lose quite a lot of money there.
Learn more about small business taxes and how they work.
Partnership (Multi-Member LLC)
If your LLC has more than one owner, the IRS defaults to partnership taxation.
The business itself doesn't pay taxes. Instead, profits and losses pass through to each owner based on their ownership percentage, and everyone reports their share on their personal return.
The LLC files Form 1065, which is an information return showing how much each partner earned. Each owner gets a Schedule K-1 from the business, and that's what they use to report income when they file their individual taxes.
Like the sole proprietorship setup, partnership income is subject to self-employment tax, so it can be simple but costly in that way.
S-Corporation
An S-Corp election changes how your LLC income gets taxed.
You're still an LLC, but now you file a corporate tax return and pay yourself a salary through payroll. That salary is subject to payroll taxes, but any profit left over after your salary gets distributed to you as a shareholder, and those distributions aren't hit with self-employment tax.
For example, if your LLC generates $100,000 in profit and you pay yourself a $70,000 salary, you only pay payroll taxes on that $70,000. The remaining $30,000 passes through without that extra tax bite.
The more profit your business makes, the more money an S-Corp can save you.
However, the S-Corp status does add complexity.
You'll need to run payroll, file quarterly payroll reports, and make sure your salary meets IRS standards for reasonableness. If you underpay yourself to avoid taxes, the IRS can reclassify your distributions as wages and hit you with penalties.
💸 Want to see if the S-Corp election makes sense for your numbers? Use this FREE Is S-Corp Worth It Calculator to get a personalized answer!
C-Corporation
A C-Corp is the only tax classification where your LLC becomes a separate taxpayer.
The business pays corporate tax on its profits at the entity level, and if you take those profits out as dividends, you pay personal income tax on them too. That's called double taxation, and it's why most small LLCs avoid C-Corp status.
That said, C-Corps often make sense for businesses planning to raise venture capital, reinvest most of their profits back into growth, or offer stock options to employees.
But if you're a service-based business or entrepreneur pulling most of your earnings out to live on, C-Corp taxation will likely cost you more than it saves.
Learn more about tax loopholes for small businesses that will likely be a better idea!
What Is the Best Tax Classification for an LLC?
There's no universal answer that works for every small business owner.
The best LLC tax classification largely depends on how much your business makes and how you want to take money out. It's also important to be honest with yourself on how much complexity you can handle.
For example, a sole proprietorship might work if you're just starting out and keeping things simple, but an S-Corp could save you thousands once your profits hit a certain threshold.
Here are a few things to consider:
How much profit your LLC makes: If you're making under $60,000 in net income, the S-Corp election probably isn't worth the extra hassle and cost right now.
Whether you're willing to run payroll: S-Corps and C-Corps require payroll, quarterly filings, and reasonable compensation, which means a lot more paperwork.
How much money you plan to reinvest versus take home: If you're reinvesting most of your profit back into the business, a C-Corp might make sense, but if you're pulling income out to live on, it'll cost you more in taxes.
Most small business owners start with the default (sole proprietorship or partnership) and make the S-Corp election once their income justifies the switch.
Learn more about converting an LLC to S-Corp.
FAQs
How Do I Know What Tax Classification My LLC Is?
If you've never filed an election form with the IRS, your LLC is taxed however it defaulted when you formed it. Single-member LLCs default to sole proprietorship, and multi-member LLCs default to partnership. If you've filed to elect S-Corp or C-Corp status, your classification changed on the date the IRS approved your election.
If you're not sure, you can confirm your current classification by checking your most recent tax return.
What Is the Tax Classification for a Single-Member LLC?
A single-member LLC is taxed as a sole proprietorship by default. In other words, the IRS ignores your LLC structure and treats you like a self-employed individual. You report your business income and expenses on Schedule C, which is part of your personal tax return. If you want a different classification, you'll need to file an election form with the IRS. You single-member LLC can be taxed as an S-Corp or C-Corp, too.
Can You Be Both an S Corp and an LLC?
Yes! An LLC is a legal structure, and an S-Corp is a tax classification. You can be an LLC that's taxed as an S-Corp, and that's an option that many small business owners choose once they start making enough income to justify the switch. Your business stays an LLC on paper (because that's how your state recognizes you), but you'll be treated as an S-Corp for taxation with the IRS.
Learn more about the pros and cons of an LLC vs an S-Corp.
Get More Clarity on Your Tax Setup
Your LLC tax classification can save you money...or cost you thousands!
However, there's no one "best" tax classification option or a one-size-fits-all strategy. It depends on your income, how you run your business, and many other factors that you need to consider.
If you're trying to decide which LLC tax classification makes the most sense for you and want someone to explain your options in plain English, book a call with our team or use our S-Corp calculator to run the math!
