One of the great features of a limited liability company is that it has numerous options for tax classification. These options include sole proprietorship/disregarded entity, partnership, S-corporation and C-corporation tax classifications.
For single member LLCs or husband and wife community property LLCs, the default tax classification is that of a sole proprietorship/disregarded entity. A sole proprietorship does not have to file any tax returns separate from those filed by the entity’s owner, and thus is considered a disregarded entity for purposes of federal income taxation. A disregarded entity is a “pass through” entity, meaning the profits and losses of the entity are passed through to the entity owner’s personal tax returns. In this case, the LLC’s single member reports the LLC’s financial activity on his or her personal income tax return on Schedule C. The individual then pays the tax associated with the LLC’s income with his or her own personal income taxes.
For multi-members LLCs, the default tax classification is that of a partnership. Partnership tax classification also means that the entity is considered a pass through entity. When an LLC is taxed as a partnership, the profits and losses of the LLC will be allocated to the individual members using a Schedule K-1, who will then pay the tax associated with their share of the LLC’s profits or losses on their own personal income tax returns.
The owner or owners of an LLC may also elect S-corporation (“S-corp”) taxation status. S-corporation tax status means that the entity taxed under subchapter S of the Internal Revenue Code. Similar to LLCs taxed as partnerships and disregarded entities, LLCs taxed as S-corporations pass the entity’s earnings and losses through to the individual shareholders, who then report the income or losses on their own personal tax returns. An LLC will not be taxed as an S-corp by default. Instead, the LLC’s member(s) must file the IRS Form 2553 to elect S-corporation tax status. Before doing so, members should ensure that the LLC is eligible to elect S-corporation status.
It is important to note that there is no such thing as an “S-corporation”. There are only entities – corporations, LLCs – taxed under subchapter S of the Internal Revenue Code. Thus, one cannot form an S-corporation. Instead, form an allowable entity (we prefer LLCs in Arizona) and then elect S-corporation taxation status with the IRS.