Because LLCs are allowed to elect pretty much any tax status that suits them, the federal returns, information statements, and notices they’re required to file each year vary accordingly. An LLC can choose the following types of taxation: disregarded entity, partnership, corporation, or S corporation.
Disregarded entity taxation
Disregarded entity isn’t so much an election as a default tax status for single-member LLCs. Single-member LLCs don’t qualify for partnership taxation because no partners exist, so they’re automatically subject to this form of taxation unless they elect corporation or S corporation tax status.
This form of taxation can actually be beneficial for some real estate and investment transactions. When considered a disregarded entity by the Internal Revenue Service (IRS), your company is treated as if it doesn’t exist, and you’re taxed simply as an individual (or as a sole proprietorship, to be exact). This arrangement can be beneficial when executing tax credits, deductions, and strategies that only apply to individuals, such as mortgage interest deductions and special exception rules in a 1031 exchange of real estate.
Partnership taxation
Partnership taxation is the default tax status for limited liability companies with more than one member. It’s a form of pass-through taxation. The primary benefit of partnership taxation over other forms of pass-through taxation is that assuming your primary intention isn’t tax avoidance. You can vary the profit and loss allocations to the partners. Additionally, recourse loans are, for the most part, deductible to the members who guarantee them.
Corporation taxation
The corporate tax status differs dramatically from all others. It’s the only non-pass-through form of taxation an LLC can elect. The company’s revenues and expenses, and thus the profits and losses, do not pass through to the members.
Instead, they are retained in the company and taxed at the applicable corporate income tax rate. Because the corporation tax rate is generally lower than what an individual pays, this status can often be beneficial.
Additionally, when a member sells their interests in the company, the profit from that sale is subject to a very favorable long-term capital gains rate. This can result in substantial tax savings. The major drawback of corporate taxation occurs when the members remove ordinary profits (calleddividends), causing a double-taxation scenario.
S corporation taxation
The corporation’s answer to pass-through taxation, the S corporation tax status came about when small, closely held businesses (such as independent contractors) needed the ability to operate under the liability protection of a corporation but without the heavy tax and regulatory burden that comes with the standard corporation.
Note that anS corporationis not an entity type. Instead, it’s simply a tax election that can be made by either a corporation or an LLC.
The S corporation’s claim to fame is the members’ ability to hire and pay themselves a salary. The resulting tax burden is ultimately equal to the income tax and self-employment tax they would pay with partnership taxation.
However, members only pay income tax on amounts over their salaries, as opposed to members subject to partnership taxation who have to pay income taxand self-employment taxon all profits over their salaries.
Obviously, you can’t just pay yourself $1 and be done with it. The IRS stipulates that your salary must be consistent with others in your industry and your position.
