If a business entity has more than one owner and is not classified as a corporation, then it is considered a partnership for tax purposes by default. Since this default classification applies to limited liability companies (LLCs), the LLC must choose to be classified as a corporation, otherwise, it will be treated as a partnership for federal tax purposes.
Similar to S corporations, LLCs taxed as partnerships are considered pass-through entities, which means the entity isn’t taxed on its income. Instead, owners are required to report their shares of the entity’s income and loss on their personal tax returns, ensuring the business income is taxed just one time and at the owner level.
The LLC allows income and deductions to pass through to its owners. If the LLC is taxed as a partnership, then Form 1065 must be filed to report income and deductions. Form 1065 details each member’s distributive share of the partnership’s income and deductions. Each partner’s share of the LLC’s income and loss must also be included in their personal tax returns.
If an LLC is taxed as a partnership, then it is generally not liable for paying the tax. Under the audit rules enacted by the Bipartisan Budget Act of 2015, audit adjustments are generally made at the partnership for tax years after December 31, 2017. As a result, the partnership can be liable for an “imputed underpayment” under the Act’s audit rules.
A single-member LLC is disregarded as an entity separate from its owner, and for federal tax purposes, is treated as a sole proprietorship, unless the owner elects to be treated as a corporation. Single-member LLCs usually offer creditor protection without requiring a separate tax return, which is why they are generally preferred for small businesses that have only one owner.
Choosing to Be Taxed as a Corporation
LLCs can choose to be taxed as either a C or S corporation. For C corporations, all income is taxed twice, once at the corporate level and also when shareholders receive distributions. Because C corporations are double taxed, they are less attractive to most small businesses. It is important to note that under the 2017 Tax Cuts and Jobs Act, there is a flat 21% corporate tax rate on income that is effective for tax years beginning after December 31, 2017. Previously, the corporate tax rate on income was 35%.
Currently, corporations pay 21% on corporate earnings, while shareholders generally pay 23.8% on dividends from the corporation. The Biden administration has proposed an increase in the corporate tax rate, so the lower corporate rate under the TCJA might change in the future. If a business chooses to be taxed as a C corporation, they must file an Entity Classification Election (Form 8832) with the IRS.
An S corporation provides the liability protection of a corporation with the flow-through taxation of a partnership. S corporations are not taxed separately from their owners but are subject to strict requirements to maintain this status. That is why most small businesses choose the LLC option. If an LLC chooses to be taxed as an S corporation, then it must file Form 2553 to elect tax treatment as an S corporation.
Do you have more questions regarding business and corporate taxes? Then please call (405) 267-9921 today or contact us online to request a consultation.