There’s no “best” type of tax designation — but there is one that’s best for you.
Building the business of your dreams is exciting. But before you can hit the ground running, you need to slow down and figure out how your business is — or will be — taxed.
Your tax designation plays a bigger role in your business than you might think. It affects how much taxes you’ll owe, how you get paid, who owns your business, what kind of tax returns you have to file and more.
As a small business owner, you’re likely an LLC — which means the most common type of tax classifications are disregarded entities, partnerships and S corporations.
Not sure which one you are? Right after you register with the IRS and apply for your EIN, this is how you’re taxed:
- If you’re an LLC with one owner, you’re taxed as a disregarded entity.
- If you’re an LLC with two or more owners, you’re taxed as a partnership.
- If you’re an LLC that’s filed Form 2553 (which has been accepted by the IRS), you’re taxed as an S corp.
Those are just your default elections and you can change it later if you’d like. But what do those actually mean? Learn how your specific tax designation affects you and your business.
|Disregarded entities vs. partnerships vs. S corps: at a glance|
Disregarded entities vs. partnerships vs. S corps: at a glance
LLCs can be taxed in a few different ways. The most common designations are disregarded entities, partnerships and S corporations. See the overview below to find out what those mean for you, your business and your taxes.
How do I become this?
How many owners?
What tax returns do I need to file?
Do I need to pay myself a salary?
Do I need to pay self-employment tax?
Disregarded entity (single-member LLC)
|Default status for LLCs with one owner||1|| Form 1040
|Default status for LLCs with two or more owners||2 or more||Form 1040 for each owner and Form 1065||No||Yes, on your share on taxable income|
|File Form 2553||1-100||Form 1040 for each owner and Form 1120-S||Yes||Only on your salary|
NOTE: LLCS MAY ALSO ELECT TO BECOME A C CORPORATION, BUT IT IS UNCOMMON.
A disregarded entity is, in most cases, a business that doesn’t require its own tax return. Its income is no different from your other personal income. Single-member LLCs, like sole proprietorships, are automatically taxed as disregarded entities. Unlike LLCs that are partnerships or S corporations, single-member LLCs without a tax election don’t have to file a separate return.
Single-member LLCs are taxed like sole proprietorships if they don’t make a formal tax election. That means they report their business income on their personal tax return. All you have to do is file your business income on Schedule C of your Form 1040. If you don’t want to keep your disregarded entity status, you can file to become an S corp.
Even though sole proprietorships and single-member LLCs can be taxed alike, there are a lot more legal advantages of registering to become an LLC.
Single-member LLCs taxed as disregarded entities are a simple structure with great benefits. Here are a few:
- Easier tax filing process: You don’t have to file an additional tax return if you’re a single-member LLC without a tax election. You only need to file your personal tax return, which is your Form 1040.
- Legal protection: Single-member LLCs can provide liability protection, unlike sole proprietorships. So you’re able to enjoy the benefits of forming a company as well as the simplicity of a sole proprietorship.
Because single-member LLCs with default taxation are so simple, they lack some of the benefits that come with other tax elections.
- Self-employment tax: You can’t pay yourself a salary as a single-member LLC owner, so you have to pay a 15.3 percent self-employment tax on top of your federal income tax. LLCs taxed as S corps don’t need to pay self-employment tax on a portion of their income.
- Sole tax liability: Since you’re the sole owner, you have to deal with all the liabilities yourself. Partnerships and S corps may have several owners to split liability between.
When you first register your LLC with two or more owners with the IRS, you’re taxed as a partnership by default.
Because a partnership is a default tax status, you don’t need to file any forms to be considered one. All you need to do is register your business with two owners. You’ll need to file Form 1065 on top of your personal income tax return, but your partnership doesn’t pay income tax itself since it’s a pass-through entity.
You can change your default partnership tax status and file to become an S corp later.
Partnerships are easy to form, offer pass-through taxation and allow you to split liability between partners.
- Splitting up taxes: You don’t have to pay income tax on all of the business’ profits. You only need to pay for your portion of taxable income. Your partners handle their portion of taxable income. This is an advantage over opening an LLC by yourself, because you’d be responsible for paying income tax on your business profits alone.
- Pass-through entity: Although partnerships (and S corps) have to file separate tax returns, they’re still considered pass-through entities — which means your business income is still treated as your personal income and taxed at your personal income tax rate.
- Easy to form: Unlike S corporations, there’s no form you need to file to become one. All you need to do is form an LLC with at least one other person and you’re good to go.
Being in business with another person has its disadvantages. That’s not the only disadvantage of being taxed as a partnership:
- Self-employment taxes: Like single-member LLCs taxed as disregarded entities, you can’t be an employee of your partnership and take a salary. You have to pay a 15.3 percent self-employment tax on top of your personal income tax. However, you only have to pay that self-employment tax on your portion of income.
- More tax forms: You have to file a Form 1065 for your business on top of your personal tax return.
- You’re not in total control: You and your partner should decide how you want to split up the ownership before you start business and contractually agree to it. Disagreements between you and your partner are inevitable — and you don’t want those to affect your taxes or finances.
An S corporation is a type of tax election that any type of LLC can make. It’s not a type of default tax election, so you would have to file Form 2553 to obtain that tax status.
Small business owners love S corp elections because they save on self-employment taxes. Unlike single-member LLC and partnership owners, S corp owners are required to pay themselves a reasonable compensation in the form of a salary. They have to pay a 15.3 percent self-employment tax on their salary, but their distributions are exempt from that tax. You can see how much that saves you with this chart.
After you become an S corp, you have to file Form 1120-S in addition to your personal tax return. Like partnerships, S corps are pass-through entities even though a separate tax return is required.
- Self-employment tax savings: S corp owners’ income is split up into two categories: reasonable compensation and distributions. Single-member LLC and partnership owners have to pay a 15.3 percent self-employment tax on all their taxable income. S corp owners only have to pay it on their salaried portion, which creates a lot of savings.
- Pass-through entity: Your business income is treated as your personal income and is taxed at your personal income rate. You’re taxed even less as an S corp owner because only part of your income is subject to self-employment taxes.
- Number of owners: Partnerships are required to have at least two owners and single-member LLCs are required to have only one. S corps can either have one owner or several — just as long as it’s under 100.
Although you save a lot in self-employment taxes as an S corp, there are still a few drawbacks you should be aware of.
- Reasonable compensation: S corp owners are required to pay themselves a salary. You can’t pay yourself an absurdly low salary either — your salary has to be reasonable in the IRS’ eyes. (Despite this, becoming an S corp can still save you thousands of dollars, depending on your business’ profits.)
- It’s sometimes not beneficial for all LLC owners: Although S corp owners don’t have to pay self-employment taxes on all of their income, making an S corp election might not always save you money. You should be earning at least $30,000 in profit before you consider making an S corp election. That’s because you may need to offset the cost of paying yourself reasonable compensation and other S corp-related costs. It’s best to talk to a CPA to see if becoming an S corp is right for you.
- More expensive to form: Since S corps are not a default tax status, you must make an election for it. There are different fees associated with making an S corp election, depending on your state. The payroll software Gusto lays out some of the major costs here.
The bottom line
There are several ways an LLC can be taxed. There are default tax elections based on the number of owners you have like disregarded entities and partnerships. You can also change your tax status to become an S corporation to save on self-employment taxes.
You should know what tax status your business has because it can dictate the forms you need to file during tax season and the way you run your business.
If you’re thinking of changing your LLC’s tax election by bringing in another owner or making an S corp election, you should talk to a tax professional to make sure the process flows smoothly — and correctly. You can schedule a free call with a DiMercurio Advisors team member today to find the support you need and more time to focus on the parts of your business you love.