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Most business owners have heard their LLC is “flexible” and that is especially true when talking about tax classifications. Your tax classification is basically what tax rules you want the IRS to apply to your business and LLCs have many options.
There are four ways LLCs can be taxed:
- As a Sole Proprietorship
- As a Partnership
- As a C Corporation
- As an S Corporation
Choosing a tax classification is based on many factors including: setup requirements, ongoing maintenance, legal compliance, raising investment, ownership restrictions, and reducing taxes.
With so many important factors at play, it’s impossible to say which tax classification you should choose. My goal with this article is to give you a detailed mental map so you can explore every possibility with your accountant and corporate attorney. Let’s go over the strengths and weaknesses of each classification.
Contents
Four LLC Tax Classifications
Start With Your Goals
When to Choose a Sole Proprietorship
When to Choose a Partnership
When to Choose a C Corp
When to Choose an S Corp
Waiting to Choose a Tax Classification
What’s Next
Four LLC Tax Classifications
| Classification | Definition |
|---|---|
| Sole Proprietorship | Income passes through to only one member. Also called a “Single Member LLC”. A default classification. |
| Partnership | Income passes through 2 or more members. Also called a “Multi-Member LLC”. A default classification. |
| C Corporation | Owners taxed separately from the business. Commonly referred to as simply a “Corporation” or “C Corp”. An opt-in classification. |
| S Corporation | Income passes through to 1 or more members. Commonly called a “Subchapter S” or “S Corp”. An opt-in classification. |
Default vs Opt-In Classifications
There are 2 groups of classifications: default and opt-in. When you incorporated your LLC with your state you were automatically given a tax classification, depending on your LLC’s number of members, by the IRS. If it’s just you then the IRS will treat you as a sole proprietorship, otherwise you and your fellow members will be taxed as a partnership. In order to be taxed as a S or C corp, you’ll need to submit special paperwork for approval to the IRS.
Start With Your Goals
Before diving into the tax classifications it’s good to get clear on your priorities. Those often include some combination of the following:
- Saving time and effort.
- Fundraising and investment.
- Reducing taxes and maximizing your profit.
Choosing a tax classification gets complicated, however setting your priorities will help you eliminate options far easier. That said don’t completely write off any options before you talk to a professional first!
When to Choose a Sole Proprietorship
Sole proprietorships have many names that basically boil down the same tax classification. These include: freelancer, contractor, and 1099. You don’t have to be an LLC to get this tax classification because by default the IRS disregards your LLC for tax purposes.
While growing your business, staying a sole proprietorship can make sense. Other classifications (like the S Corp) have big tax savings, however you generally need to have income from your business to make it worthwhile. LLC owners usually keep their sole proprietorship status because it’s “fine for now”.
Pros & Cons
- Pro: No paperwork to setup.
- Pro: Qualified Business Income (QBI) deductible up to 20%.
- Pro: Smallest amount of filings and upkeep effort.
- Con: Taxed on earnings even when not distributed.
- Con: Pays full self employment taxes.
Taxes Paid
| Name | Amount |
|---|---|
| Self Employment | $$$ |
| Payroll | - |
| Income Taxes | $$$ |
| Corporate Taxes | - |
Generally all sole proprietor’s income will be classified as self employment income and treated as ordinary income. While you get to save on all the little payroll taxes (employees have to pay), self employment and income taxes will eventually take a heavy toll. On the plus side your LLC income is likely “qualified business income” eligible for a large QBI deduction of up to 20 percent!
Filings & Upkeep
IRS forms you may have to file include:
- Schedule C
- Schedule SE
- 1040-ES (quarterly)
Aside from your general LLC maintenance, a sole prop has the most minimal upkeep of all the options. The filings are generally straightforward and most tax software can easily and affordably knock them out for you.
You’ll spend the most time on quarterly upkeep: filing form 1040-ES making sure your estimated taxes get paid. You may not need to do this when you expect to owe less than $1,000 in taxes from your business income.
When to Choose a Partnership
When two or more people join together to operate a business, they’ve started a partnership in the eyes of the IRS. If you’ve started an LLC with another member, the IRS instantly considers you a partnership for tax purposes. The IRS will disregard your LLC for taxes and all income will pass through to the members.
LLC owners generally opt to keep their partnership tax classification for flexibility and/or avoiding extra upkeep. While they require more filings and maintenance than sole proprietorships, it’s typically far less than S and C Corp requirements. When ownership flexibility is less of a concern, partnerships can also be considered “fine for now” while taxes are less expensive.
Pros & Cons
- Pro: No paperwork to setup.
- Pro: Qualified Business Income (QBI) deductible up to 20%.
- Pro: Owners can be individuals, LLCs, or corporations.
- Pro: Members or owners can be foreign residents.
- Pro: No limit on number of members allowed.
- Con: More upkeep and filings needed than sole props.
- Con: Taxed on earnings even when they are not distributed.
- Con: Members pay full self employment taxes.
Taxes Paid
| Name | Amount |
|---|---|
| Self Employment | $$$ |
| Payroll | - |
| Income Taxes | $$$ |
| Corporate Taxes | - |
This table is for member managers actively involved in running the business. It does not include capital gains taxes paid on limited partner (passive shareholder) distributions. Typically partnership income will be distributed based on ownership as self employment income. Member managers will have to pay full self employment and income taxes on their entire partnership earnings. Partnerships usually consider the S Corp for reducing their taxes.
Filings & Upkeep
IRS forms you may have to file include:
- Form 1065
- Schedule K-1
- Schedule E
- Schedule SE
- 1040-ES
While filings are similar to a sole proprietorship, there’s a few additional IRS forms such as the 1065 and K-1. The filings above can generally be covered by most business tax software, however you may need to purchase a more expensive version. Usually upkeep will be less than S and C Corps because you don’t usually need to deal with quarterly payroll and corporate filings.
The most time consuming maintenance for each partner is the quarterly filings of form 1040-ES along with your estimated tax payments. When you expect to owe at least $1,000 in taxes from your share of the partnership income for the year you’ll need to do this.
When to Choose a C Corp
You can opt to have your LLC taxed like a corporation, just like the big dogs traded on Wall Street. While there are great reasons to choose this tax classification, please don’t do so without understanding the significant tax tradeoffs. C Corporations have gained in popularity in recent years due to the startup community’s courtship of venture capitalists. While making investment decisions easier for your investors is important, it should not be your only concern.
When your primary focus is fundraising and/or “going public” then the C Corp could likely be at the top of your list. That said, realize you’re likely going to be paying more in overall taxes due to the double taxation at the corporate and individual level. When you’re trying to build a large business and scale massively as fast as possible, this may be your only option.
This is where knowing your goals and what kind of business you want to build is critical. Startup investors will generally always tell you to be a C Corp because it’s easier for them, not necessarily better for you. Before choosing a C Corp over an S Corp carefully weigh the benefits against your priorities, not just those of your would be investors.
Pros & Cons
- Pro: Can retain earnings within the company without getting taxed
- Pro: Perpetual existence
- Pro: No restrictions on ownership for individuals, nonresidents, LLCs, & corporations
- Pro: Easiest for fundraising via venture capital
- Pro: Ability to offer stock options
- Pro: Useful in more complicated tax strategies
- Pro: Many business deductions possible
- Pro: TCJA recently reduced the top corporate tax rate from 35% to 21%.
- Con: Not eligible for the qualified business income (QBI) 20% deduction.
- Con: Subject to expensive corporate level taxation.
- Con: Requires paperwork to setup.
- Con: More compliance and upkeep needed.
Taxes Paid
| Name | Amount |
|---|---|
| Self Employment | - |
| Payroll | $$ |
| Income Taxes | $$ |
| Corporate Taxes | $$$ |
This table is for shareholders that are also managers, taking a salary from their C Corp. It does not consider capital gains paid on shareholder dividends. Unlike Sole Proprietorships and partnerships we are finally avoiding those self employment taxes, but encountering a very similar tax we are calling “payroll”. Payroll also includes many smaller taxes such as unemployment.
The major item to consider is corporate taxes which are expensive and have a state level tax in addition to the federal. This isn’t always a deal breaker and skilled accountants use the C Corp in more sophisticated tax strategies. Great book to learn more about this is Start your Own Corporation by Garrett Sutton.
Filings & Upkeep
IRS forms you may have to file include:
- Form 8832
- Form 1120
- Payroll forms (Quarterly & Annually)
Corporations have more upkeep, maintenance, and compliance than partnerships do. Some of these requirements include: holding shareholder meetings, holding board of directors meetings, state registration fees, and state filings to name few.
Quite a bit of time will also be spent on “running payroll” on your salaries and filing the quarterly reports in order to report them.
When to Choose an S Corp
S Corporations are a tremendously overlooked option for business owners looking to reduce taxes. While still a pass through entity claiming big tax deductions, they also allow owners to take non-salary compensation similar to a C Corp dividend. In the pros & cons below you’ll see a lot more cons than pros largely because of the many ownership restrictions S Corps have. However don’t let that distract from the major pros!
Venture capitalists may not get as excited about S Corps as the owners building the business do. That’s because S Corps trade ownership flexibility for huge tax saving on self employment taxes. That said the ownership restrictions are still very workable for many businesses. For those of you that want to maximize the profits of your business, the S Corp is a wonderfully straightforward tax strategy!
You can try our free S Corp tax savings calculator to see if your LLC could save on taxes. There’s no sign up required.
Pros & Cons
- Pro: Qualified Business Income (QBI) deductible up to 20%.
- Pro: No corporate level taxation.
- Pro: Pays less self employment taxes.
- Pro: Can leverage health insurance premiums to further reduce self employment taxes.
- Con: Requires paperwork to setup.
- Con: More compliance and upkeep needed.
- Con: Taxed on earnings even when they are not distributed.
- Con: Limited to 100 members.
- Con: Only one class of common stock.
- Con: Members must be a U.S. resident (no nonresident aliens).
- Con: Owners must be individuals not corporations or other LLCs.
Taxes Paid
| Name | Amount |
|---|---|
| Self Employment | - |
| Payroll | $ |
| Income Taxes | $$$ |
| Corporate Taxes | - |
This table is for members that are also managers, taking a salary from their S Corp. It does not consider capital gains paid on limited partner distributions or compensation beyond a member’s stock basis. The major advantage over sole proprietorships and partnerships is how much self employment taxes are avoided. Even though you're encountering a very similar tax we are calling “payroll” here, it’s usually far less than what you would be paying otherwise. Please note that payroll also includes many smaller taxes such as unemployment.
Filings & Upkeep
IRS forms you may have to file include:
- Form 2553
- Form 1120-S
- Schedule K-1
- Payroll forms (quarterly & annually)
S Corps have more upkeep, maintenance, and compliance needs than partnerships will. Some of these requirements include: holding shareholder meetings, board of directors meetings, state registration fees, and state filings.
Quite a bit of your attention will be towards “running payroll” on your salaries and filing the quarterly reports in order to report them.
Waiting to Choose a Tax Classification
Unless you're raising funding in the near future, it can make sense to wait to make this decision. S Corps can save a lot on self employment taxes, but only for businesses that are earning enough income to justify the switch. If your business is still early on it often makes more sense to focus your time and attention on growing your business, less on minimizing your taxes.
Next Steps
We’ve explored every option your LLC has for being taxed: sole proprietorship, partnership, C Corp, and S Corp. You should be fairly well versed in the trade offs and advantages each tax classification can offer you. One key point to take away: there is no one right answer for every business. Now that you know the role each tax classification plays you can begin to form a plan with your accountant and corporate attorney.
Making a decision based on this article alone would be a mistake! Ultimately, you’ll need to bring the full context of your business to a professional that can help you weigh the complex concerns of: investors, legal compliance, tax savings, and asset protection. Each one of these deserves its own careful consideration.
Most importantly, I hope you are aware that your priorities as the business owner should come first. Increasingly business owners overlook all their options to make their investors happy, when the ultimate success or failure of the business rests on them! If you haven’t already, make sure your goals and priorities for your company are clear to you. Knowing what you want your business to be in the future makes it far more likely you’ll pick the right tax classification the first time.
If you’re interested in how much you could be saving on taxes with an S Corp, please try our tax savings calculator. It’s completely free, zero sign up, and accounts for even the smallest state level taxes.
