By Bert Seither, Director of Operations at Corporate Tax Network
About the author: Bert Seither is the Director of Operations at Corporate Tax Network, a national accounting and business development firm. For nearly 10 years, Seither has assisted small business owners to help put their companies on a path to prosperity.
Limited liability companies (LLCs) offer lots of flexibility to their owners. One option LLC owners have is to choose how they want their businesses to be taxed, also known as the entity classification election. Because of IRS tax rules on businesses, it’s vital to weigh the options involved in making this election and how the resulting tax structure of a business will affect the tax obligations of those who own it.
An LLC can fall under several different structural categories – an S corporation, a C corporation, a sole proprietorship, or a partnership. Deciding which structure to adopt for an LLC is based on several factors, including the number of owners it has. The decision that ultimately leads to how an LLC is treated by the IRS is called the entity classification election. This election is made when a business files its taxes using Form 8832: Entity Classification Election. For an S Corporation, Form 2553 may have to be submitted as well, or it may be filed separately.
S corporations are not taxed directly at the corporate level; instead, the shareholders invested in them split the taxes on their personal income tax returns. As for C corporations, they are taxed at the corporate level as separate business entities. Sole proprietorships and partnerships have their taxes passed directly to those who own these types of entities, but they can still use the LLC designation and operate under either structure.
There are various reasons why it’s important to understand how this election works. Basically, the entity classification election is designed to clarify to the IRS how an LLC owner wants a business to be treated from a taxation perspective. This election will have an effect on the tax status of the business and could have a significant impact on how much money the business must pay in federal taxes and how much income its owners will be able to keep. There are both pros and cons involved in each election option, so considering what works best for a business owner is key.
If an LLC owner fails to indicate to the IRS the classification he or she desires for the company, it could be taxed in a way that is less desirable and results in higher tax obligations. This is because the IRS will make the assumption that a business owned by one person is a sole proprietorship, while one with multiple owners is a partnership. In the case of a sole proprietorship, the business owner must generally file their business-related taxes on a personal return. The same rule of thumb applies to partnership owners who divide up their income and report it on their personal returns. Letting the IRS default an LLC to these informal business designations, though, could lead to much higher tax rates and fewer opportunities for tax deductions. This demonstrates the major importance of making an appropriate election for an LLC.
After these forms are filed with the IRS, an LLC owner should receive an answer on the election of choice by mail. The election must be made within 75 days of submitting this paperwork. While this 75-day period may seem like enough time, making the election on time is essential to put an LLC in the right category for future taxation purposes.