How to Choose a Tax Classification for an LLC
LLC owners can choose the tax classification that is most advantageous to them. The choice is usually between the default classification—either disregarded entity or partnership, depending on whether there are multiple owners—or electing to be taxed as an S corporation to save self-employment taxes. This article discusses these options and provides practical guidance on choosing the right tax classification for an LLC.
Default LLC Tax Classification Rules
LLCs do not have a required tax classification. They are taxed using the tax system that applies to other entity types and—under a system of regulations called the check the box regulations—can choose which tax classification to apply. As a result, an LLC may be taxed as a sole proprietorship, partnership, C corporation, or S corporation, depending on the number of owners and their goals.
Most LLC owners want to avoid double taxation. Unless the owners elect otherwise, the Internal Revenue Code applies pass-through taxation to LLCs by default. The specific default tax classification of an LLC depends on the number of owners:
- Single-member LLCs. If the LLC is owned by one owner (a single-member LLC), the LLC will be disregarded for tax purposes. Assuming that the owner is an individual, the U.S. tax law treats the owner as a sole proprietor. The owner reports all LLC income on the owner’s income tax return as though the LLC did not exist.
- Multiple-member LLCs. If the LLC has more than one owner for tax purposes, the LLC is taxed as a partnership by default. The LLC will file an information return with the IRS and issue Schedule K-1s to each owner at the end of the year.
In both cases, the default classification does not tax the LLC separately from the owners. The Internal Revenue Code passes all income through to the owners and taxes the owners on their income tax returns. This pass-through system avoids avoid the double taxation that applies to C corporations.
Changing the Default Classification
Founders that want to change the default classification can do so by electing to have the LLC taxed as either a C corporation or an S corporation. This flexibility gives LLC owners a choice between three tax classifications:
- Default classification. The LLC can accept the default classification as a partnership or sole proprietorship, in which case no additional filing is required.
- C corporation election. An LLC may elect to be treated as a C corporation by filing a Form 8832, Entity Classification Election, with the IRS. Once the LLC elects to be taxed as a C-corporation, it must file a Form 1120, U.S. Corporation Income Tax Return, to report its income as a corporation.
- S corporation election. An LLC may elect to be treated as an S corporation by filing Form 2553, Election by a Small Business Corporation, with the IRS. The LLC must make the election within two months and 15 days of the beginning of the LLC’s taxable year when the election is to go into effect. There is no need to file Form 8832 first. Filing the Form 2553 collapses the steps, so that the LLC is treated as both changing its status to a corporation and making a subchapter S election for the corporation.
Most LLCs are formed specifically to avoid being taxed as a C corporation. If there is a specific and compelling reason for a business to be taxed as a C corporation—for example, if the business is a high-growth startup—then the business will almost always be organized as a corporation instead of an LLC, eliminating the need to consider whether an LLC should be taxed as a C corporation.
Because there is rarely a reason for an LLC to be taxed as a C corporation, the only choice is whether the LLC should accept the default classification—disregarded entity for single-member LLCs or partnership for multi-member LLCs—or elect to be taxed as an S corporation.
Benefits of Accepting the Default Classification
Although both the default classification and S corporation classification avoid double taxation, the default classification offers several benefits over S corporation classification.
The Default Classification Doesn’t Include Eligibility Requirements
To be taxed as an S corporation, LLCs must meet the eligibility requirements of subchapter S of the Internal Revenue Code. These requirements—which are discussed in more detail in our discussion of S corporation eligibility—include:
- Owner eligibility. All LLC owners must be individuals, decedents’ estates, bankruptcy estates, certain types of trusts, or charitable organizations. If a corporation or partnership will own part of the LLC, for example, the LLC is not eligible to elect to be taxed as an S corporation.
- Citizenship requirements. If an owner is not a U.S. citizen and does not pass one of the two tests for be considered a resident alien, the LLC is not eligible to make a subchapter S election. The same is true if an owner’s spouse is a nonresident alien that is considered to own an interest in the LLC under community property law or other state law.
- Limited number of owners. Subchapter S also requires the LLC to have no more than 100 owners, each of whom must consent to the subchapter S election. If the LLC will have more than 100 owners, or if any of the owners refuse to consent to the subchapter S election, then the LLC may not elect to be taxed as an S corporation.
- One class of equity. The LLC can only issue one class of equity. Although differences in voting rights are allowed, the economic rights of the owners must be identical. This rule prohibits the use of liquidation or distribution preferences and incentive equity.
The default classification avoids these requirements. LLCs that are disregarded for tax purposes or taxed as partnerships can have any number or type of owners and can issue multiple classes of equity. The absence of eligibility requirements makes the default classification much more flexible than the S corporation classification.
The Default Classification Makes It Easier to Capitalize the Business
When forming a new business, the founders will often transfer money or property to the business as operating capital. In many cases—especially in the real estate context—the owners may wish to transfer appreciated property to the business.
The contribution of appreciated property to a business can create tax problems. If not handled correctly, the contribution could be treated as a sale to the business, resulting in taxable gain to the owner that contributes the property.
To avoid paying tax on a contribution of property, the LLC must select a tax classification that does not tax built-in gain when property is contributed to the LLC. The default classification rules make this easy. Regardless of whether the LLC is a multi-member LLC taxed as a partnership or a single-member LLC that is disregarded for tax purposes, contributions of property to the LLC are not taxable events.
If the LLC elects to be taxed as an S corporation, things get more complicated. A contribution of property to an S corporation is treated as a taxable sale unless, immediately after the contribution, all of the owners that contributed property “control” the business. In this context, “control” means ownership of equity possessing at least 80 percent of the total voting power of all classes of voting equity and 80 percent of each class of nonvoting equity. This control requirement makes it more difficult for owners to contribute property after the business is formed, especially if the owner contributing the property owns less than 80 percent of the company.
The Default Classification Taxes Pre-Contribution Gain to the Contributing Owner
The contribution of appreciated property to a business can also create tax issues between founders. The partnership tax rules ensure that the owner that contributes appreciated property is ultimately taxed on the appreciation. When the partnership sells the property, the owner that contributed the property is taxed on the built-in gain. This rule protects the other owners from being unfairly taxed on built-in gain that accrued before the property was contributed to the business.
The S corporation rules include no such protection. If an owner contributes appreciated property to an LLC taxed as an S corporation, and the LLC later sells the property, each owner must pay a portion of the tax on that gain. That is true even though the gain relates to the period before the owner contributed the property to the LLC. While this is beneficial to the owner that contributed the appreciated property, it is usually unfair to the non-contributing owners.
The Default Classification Allows the LLC to Issue Different Classes of Equity
Many businesses use preferred classes of equity to give some owners different economic rights than other owners. For example, one investor may contribute most of the operating capital to the business and want to recoup that investment before distributions are made to the other owners.
LLCs that are taxed under the default classification can issue equity (membership interests) with different economic rights. The operating agreement may create a class of preferred equity with distribution or liquidation preferences that give the holders of that equity different economic rights from other owners. The ability to create classes of equity with different economic rights allows the LLC to accommodate most business deals between the owners.
As mentioned above, LLCs taxed as S corporations cannot issue multiple classes of equity. Although differences in voting rights are allowed, each owner must have identical economic rights. The LLC cannot issue preferred or incentive equity. Instead, the LLC must distribute all earnings among the owners in proportion to their interests in the LLC. Even if one owner contributes most of the capital, that owner cannot recoup his or her investment more quickly than the non-contributing owners. This restriction frustrates many common business arrangements.
The Default Classification Allows LLCs to Use Incentive Equity
Incentive equity is equity provided to service providers as part of their compensation. Founders commonly use incentive equity to attract, retain, and motivate key employees. The ability to issue incentive equity is often a key factor in the growth of a business.
Corporations that issue incentive equity often use incentive stock options, non-qualified stock options, or restricted stock as incentives for their employees. LLCs do not issue stock, but LLC membership interests (equity in the LLC) can be structured to incentivize employees.
The most common form of incentive equity for LLCs is a profits interest. A profits interest gives the holder the right to share in the LLC’s future growth, but no right to the entity’s assets at the time that the interest is granted. As long as the LLC is taxed under the default classification as a partnership, it can issue profits interests as incentive equity.
The ability to issue profits interests is lost if the LLC is taxed as an S corporation. Because LLCs taxed as S corporations cannot issue classes of equity with different economic rights, they may not create special classes of incentive equity to motive and retain key employees.
The Default Classification Allows LLCs to Make Special Allocations
An LLC’s income, deduction, and related tax items are divided among the owners through a process known as allocation. By default, LLC allocations are made in proportion to the owner’s interest. If Owner A has a 75 percent interest in the LLC and Owner B has a 25 percent interest in the LLC, then Owner A is taxed on 75 percent of the income and Owner B is taxed on 25 percent of the income.
If the LLC is taxed as a partnership, the owners can change the default allocations by making special allocations that distribute income tax items disproportionately among the members. This flexibility is lost if the LLC elects to be taxed as an S corporation. The S corporation rules require all income, loss, and other tax items to be allocated among the owners on a pro rata basis.
The Default Classification Allows LLCs to Make Tax-Free Distributions of Property
LLCs may distribute company property to an owner. If the property is appreciated, it is important for the LLC’s tax classification to treat the distribution as a tax-free transfer. An LLC taxed as a partnership may distribute property to the owners with no immediate tax consequence. Neither the LLC nor the owner is taxed on the transfer.
If the LLC is taxed as an S corporation, the Internal Revenue Code treats the LLC’s transfer of property to the owner as a taxable sale. Any gain resulting from the deemed sale is taxed to the owner.
The Default Classification Provides Basis Planning Opportunities
Founders benefit from an LLC tax classification that provides opportunities to increase basis. A higher basis allows owners to shelter more income, take higher deductions, and save taxes on the sale of equity in the business.
LLCs taxed as partnerships have three basis advantages over LLCs taxed as S corporations:
- Redemptions. When an LLC taxed as a partnership redeems the ownership interest of an owner, the remaining owners can get an increased basis in the LLC’s assets (inside basis step-up). This inside basis step-up allows the remaining owners to save taxes when partnership assets are sold. If the LLC is taxed as an S corporation, there is no increase to the LLCs inside basis in its assets on the redemption of an owner.
- Increased basis for LLC debt. The default partnership classification that applies to LLCs with multiple owners allows the owners to include LLC debt in the basis of their ownership interests (outside basis). This basis increase allows the owner to deduct losses in excess of the owner’s capital investment. This benefit is not available if the LLC is taxed as an S corporation.
- Increased basis on sale of equity. When a buyer acquires an interest in an LLC taxed under the default classification, the buyer can step-up the basis of the partnership’s assets (assuming, in the case of LLCs taxed as partnerships, that a 754 election is in place). The value of the basis step-up can be separately modeled and added to the purchase price. If the company is profitable, this increase makes the business more attractive to a buyer and has real economic value to the seller.
These advantages allow the owners of LLCs taxed as partnerships to increase both inside basis and outside basis, placing them in a better tax position than owners of LLCs taxed as S corporations.
When to Elect to Have an LLC Taxed as an S Corporation
As described above, the default classification offers several advantages over S corporation classification. But LLCs taxed as S corporations have two advantages over LLCs that use the default classification:
- Self-employment taxes. Most LLC owners that elect to be taxed as S corporations do so to save self-employment taxes. Under the default LLC tax classifications, all owners that are active in the business must pay self-employment taxes on all income earned by the LLC. If the LLC elects to be taxed as an S corporation, the owners can divide the LLC’s income into wages (which are subject to self-employment tax) and dividends (which are not). See How to Save Employment Taxes with S Corporations for more information about this strategy.
- Lower taxes on sale of hot assets. If an LLC is classified as an S corporation, the sale of the LLC’s equity is treated as the sale of a capital asset and taxed at preferential capital gain rates. The same is true for the sale of an LLC taxed under the default classification, with one exception: A sale of unrealized receivables and inventory items (hot assets) are taxed at higher rates as ordinary income. If the LLC is sold and a substantial portion of the business value involves hot assets, the seller will prefer that the business be taxed as an S corporation so that the entire equity sale qualifies for preferential capital gain treatment.
In either situation, an S corporation election may provide a better tax result than the default classification.