There are a number of factors to consider when deciding which entity type to choose for LLC tax purposes. Each business structure is unique, and the tax laws change quite often. Therefore, you should seek the advice of a CPA and/or tax attorney who can evaluate your business and help you make this decision.
When deciding which tax treatment works best for an LLC, consider how profits will be taxed, how the owners will be compensated, how to handle losses if the LLC is losing money, which entity type results in the lowest LLC taxes, and if you’ll need to pay self-employment or FICA taxes.
The five key factors to consider when choosing your LLC tax treatment are:
With sole proprietors, partnerships, and S-corps, all income and expenses are passed through to the owners’ entities and taxed once. However, when it comes to a C-corp, all profits are taxed at the corporate level and then again when profits are distributed to each shareholder in the form of dividends. This is called double taxation.
However, C-corps do not necessarily need to pay out dividends every year. And sometimes owners can pay zero tax on C-corp dividends. Thus, in some situations, C-corp entities can result in lower LLC taxes on profits. Since this is a significant tax planning opportunity for the LLC members, the members should seek advice from an attorney and a certified public accountant.
For LLCs treated as S-corps, the net earnings of the LLC are subject to ordinary tax rates on the owner’s personal tax return. There is no self-employment tax on the S-corporation’s net earnings.
For LLCs treated as C-corps, the net earnings of the LLC are subject to the corporate tax rate. Currently, the corporate tax rate is a flat 21% on net profits. There is no self-employment tax on the C-corporation’s net earnings.
The owners of an LLC taxed as an S-corp or as a C-corp must be treated as employees of the company and draw a reasonable salary. This can be a benefit to the owners if the LLC is profitable and they have high Social Security and Medicare taxes.
The benefit here is that the Social Security and Medicare taxes (also known as FICA taxes) for the owner’s salary could be less expensive compared to the self-employment tax that applies to sole proprietors and partnerships.
FICA taxes often come out less than the self-employment tax for four reasons:
Owners must pay themselves a reasonable salary. This means the salary paid to the owners must be appropriate given the nature of the work they perform.
If an LLC taxed as a sole proprietor, partnership, or S-corp reports a loss, operating losses will pass through to the owner’s personal tax return for LLC tax purposes. This can result in a lower tax bill for the owners. In contrast, a loss on LLC tax returns for a C-corp will just carry forward and offset future earnings of the company.
The overall tax bill for an LLC taxed as a sole proprietor, partnership, or S-corp could be lower than a C-corp. That’s because the taxes for these three entities are based on the individual tax rate of the owner, as opposed to a corporate tax rate of the C-corp.
Owners of sole proprietorships and partnerships pay self-employment taxes on their net earnings from the LLC. On the other hand, the owners of S-corps and C-corps pay FICA taxes on their salaries.