Many businesses tend to choose a Limited Liability Company (LLC) set up to avail of the benefits and owners protection that’s often associated with this business setup. Yet, there are specific details that one must take note of to maximize the profit and fully leverage the position of having an LLC.
Choosing the most appropriate tax classification for your LLC is a crucial business decision. Depending on your organization’s goals, there are default classifications an LLC can choose from. Note that other business structures are imposed with specific tax classifications as opposed to LLCs which can select their own.
This makes LLCs one of the most popular business models.
Default tax classifications
LLCs are assigned with the status of “pass-through” entities. This means that they are taxed through their members. In this case, a person or entity pays the business’s tax through their tax return.
This is significantly favorable compared to a C Corporation that is obligated to pay 21% corporate income tax before they disburse the earnings to their shareholders through dividends. These are subsequently charged with income tax at the individual level. This is the “double” taxation that the majority of the LLC members wish to avoid.
An LLC’s specific tax classification will depend on the number of its owners.
For single-member LLCs (an LLC owned by one owner), the U.S. tax law treats the owner as a sole proprietor. This disregards the LLC for tax purposes entirely. The owner simply reports the LLC’s income via their income tax return.
For LLCs that have more than one owner (Multiple-Member LLCs), the company is taxed as a partnership. This is similar to the method of taxation for sole proprietorship wherein taxes incurred are passed through directly to the members of the company.
Opting for other tax classifications
LLC’s have flexibility as one of their advantages. They may choose to stick with the default classification assigned to them or opt for either the C Corporation or S Corporation taxation.
For the C Corporation classification, the LLC will be taxed as a separate business entity. This means that taxes incurred by the business do not pass through the members’ taxes. Setting up these types of LLC tax classifications can be tedious and complicated for most business owners. However, it also has some advantages due to the separation of the owner’s personal and business revenues. Although this advantage is often overshadowed by the looming disadvantage of double taxation.
Meanwhile, choosing the S Corporation classification means that the LLC will be treated as a corporation. This will transfer all taxes incurred from business operations to the personal tax liabilities of the LLC’s members. This, likewise, has advantages such as avoiding double taxation. However, the process of changing the default tax classification may be tedious and complex. There are certain eligibility requirements to be taxed as an S corporation such as owner eligibility, a limited number of owners, and citizenship requirements.
Why choose the default classification?
Choosing the default tax classification brings several benefits to be considered by the LLC members. One of these is the ease of transaction. By choosing the default, no eligibility requirements would be necessary.
Consider that applying for an LLC is not an automatic procedure. That may take a significant amount of time and effort.
Opting for the default tax classification also brings the advantage of flexibility on the table. Although the S Corporation classification also avoids double taxation, remember that this transforms the LLC into a rigid structure with a required number of elections yearly. It also limits the LLC to one class of equity. This cancels the use of liquidation or distribution preferences as well as incentive equity.
LLCs are usually the business type of choice for startup owners that intend to spend their time and decision-making on things that would make their companies go forward. Opting for the default taxation is usually best for LLCs.