LLC and Federal Tax Classification

By Yigang Xu, CPA
XU CPA, LLC
Greenville, SC
www.mygreenvillecpa.com

A limited liability company (LLC), in the plainest language, is a hybrid entity sharing elements of a regular corporation (for limited liability) and a partnership or a sole proprietorship (for income flow through). It is not to be confused with a regular corporation, because it is not incorporated, but a form of union or association of persons for carrying on an enterprise.

A LLC is relatively easy to form than a corporation, and it is very flexible for federal income tax purpose. Since it is a hybrid entity, it can actually be taxed as 1) a sole proprietorship, 2) a partnership, and a 3) regular corporation, which further can be taxed as an S corporation. There are just a lots of flexibility.

​Default Treatment:

If domestic LLC does not make any federal tax classification by filing Form 8832, it is by default:

1. A partnership, if there are more than two members;
2. Disregarded as an entity separate from its owner if there is only one member.

A partnership files tax Form 1065, its income or loss flows to its members, and members are subject to self-employment tax. A disregarded entity does not have its own tax return, but the owner reports the activities on Schedule C of his or her own Form 1040, like a regular Schedule C, income is subject to self-employment tax.
8832 Classification and 2553 Election:

Or an LLC can file Form 8832 and classify the entity to be taxed as a corporation, once it has elected to be treated as a corporation, it can further file Form 2553 to elect to be treated as a subchapter S corporation. An S corporationfiles tax Form 1120S, its income or loss flows to its members, but the income is not subject to self-employment tax nor the additional Medicare tax of 2013. This is a huge advantage illustrated below:

•  If your business generates a net income of $100,000, and you do not make the S corporation election, this flow through income will be subject to an SE tax of $ 15,300 (12.4% for FICA and 2.9% for Medicare), but if the entity is an S corporation, you will not be subject to SE tax, which is a $15,300 saving in this scenario. Further, an additional Medicare tax of .9% is levied on certain income over various threshold starting in 2013, but S corporation income is not subject to this new Medicare tax.

Summary:

An LLC is a very flexible business entity that is relatively easy to start, with or without an operating agreement, it is not to be confused with a corporation, as it is not an incorporated entity. It has various options regarding to federal taxation, entity can make election to be taxed as an S corporation or just follow the default treatment. But an S corporation election has its unique feature of having its income not subject to self-employment tax. If this particular feature is very important to taxpayer, an S corporation election is a choice tax election for many small business owners.

Thanks for reading.

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Disclaimer: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

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