When forming an LLC, choosing how you want to be taxed is one of the most critical decisions you’ll make. With four taxation options to consider—Partnership, Disregarded Entity, S Corporation, and C Corporation—it’s essential to understand how each one works and the impact it will have on your tax situation. The way your LLC is structured, whether it’s member-managed or manager-managed, also plays a role.
So, let’s dive in and break this down in simple terms so you can make the best choice for your business!
The Four LLC Taxation Options
- Disregarded Entity: If you’re a single-member LLC and don’t file an election, the IRS treats your LLC as a disregarded entity. For tax purposes, this means all income flows directly onto your Schedule C of your personal tax return, just like a sole proprietorship.
- Partnership: For LLCs with two or more members, the default taxation status is a partnership. Here, the LLC doesn’t pay federal taxes directly. Instead, income flows through to each partner’s personal tax return via a K-1.
- S Corporation: Want to save on self-employment taxes? Filing Form 2553 to elect S Corporation status may be the way to go. This allows the owners to take a salary (subject to payroll taxes), and the remaining profits can be distributed without paying employment taxes.
- C Corporation: Electing to be taxed as a C Corporation means the LLC is treated as a completely separate entity for tax purposes. The corporation pays its own taxes on profits, and any dividends paid to owners are taxed again on the personal level—what we call double taxation.
Default Rules for LLC Taxation
Understanding the default rules is key:
- If you’re a single-member LLC and don’t file any election, your LLC is treated as a disregarded entity.
- If you have two or more members, the default classification is a partnership, unless you file Form 8832 to elect corporate taxation or Form 2553 for S Corporation status.
So, let’s say you and a business partner form an LLC. By default, you’re taxed as a partnership. But if you prefer to be taxed as an S Corporation, you need to file Form 2553 with the IRS.
Distributions from an LLC: What You Need to Know
Once your LLC is up and running, there will come a point where you’ll want to distribute profits to yourself or your partners. How those distributions are taxed depends on the tax status of your LLC.
- Single-Member LLC (Disregarded Entity): If your LLC is disregarded for tax purposes, any income and expenses are reported on your Schedule C. You won’t take a payroll from the LLC, but you’ll receive profits directly, which are subject to self-employment taxes.
- S Corporation: If your LLC is taxed as an S Corporation, the active owner(s) must take a reasonable salary through payroll, which is subject to payroll taxes. Any additional profits can be distributed to owners, and those distributions aren’t subject to employment taxes. This is a key benefit of the S Corporation election.
- C Corporation: If your LLC is taxed as a C Corporation, distributions are called dividends. Keep in mind that dividends are not deductible by the corporation, and they’re taxed again on your personal return, leading to double taxation.
- Partnership: In an LLC taxed as a partnership, there is no payroll for partners. Instead, profits are distributed to each partner based on their ownership percentage or as agreed in the operating agreement. Partners who actively manage the business may receive guaranteed payments, which are subject to employment taxes, but not considered payroll.
How to Make LLC Distributions the Right Way
Making distributions sounds easy, right? You just write a check to yourself or your partners. But there’s more to it, especially if you want to avoid tax trouble down the road.
First, make sure you know the financial health of your LLC. Distributing too much cash when your LLC has outstanding liabilities could lead to fraudulent conveyance issues, making you personally liable to creditors for wrongful distributions. Keep your accounting records accurate from day one.
Here’s an important tip: Distributions should reflect ownership percentages unless your operating agreement states otherwise. For example, if you and your partner own an LLC 50/50 and the LLC generates $10,000 in profit, each of you should receive $5,000. However, it is possible (though rare) for profits to be distributed disproportionately—but this must be clearly outlined in your operating agreement.
Be Cautious with Profit Distributions and Taxes
One big trap many LLC owners fall into is not realizing that distributions don’t always cover taxes owed on the LLC’s profits. If your LLC generated $100,000 in profit but only distributed $50,000, you still owe taxes on the entire $100,000!
That’s why it’s critical to plan ahead and ensure your LLC has enough funds to distribute profits to cover your tax bill. Otherwise, you’ll have to pay taxes out of your pocket without receiving any cash from the business.
Final Thoughts: Formalities Matter
Don’t overlook the importance of maintaining proper LLC formalities. Just forming an LLC isn’t enough—make sure you’ve got an operating agreement that reflects your members, your tax structure, and how profits will be distributed. This will not only help you avoid costly legal issues but also ensure the IRS respects your LLC’s separate entity status.
When in doubt, get expert advice. Having a well-structured LLC from the beginning can save you headaches, taxes, and legal trouble down the road.
