Whenever you establish a business, it receives a type of tax treatment automatically from the IRS.
The good news is that, if you’re not down with your default tax treatment, business entities have some leeway when it comes to changing how they’re taxed. The exception is sole proprietors, who can’t change their tax treatment.
What’s the default tax treatment for a single-member LLC (SMLLC)?
The answer is “disregarded entity,” which is basically a fancy way of saying that the IRS pretends that the LLC doesn’t exist. This means that the owner of the SMLLC is taxed like a sole proprietorship. A sole proprietorship is a one-owner business that’s personally owned by the proprietor (aka the owner), and it’s the simplest way to organize and run any business.
For this article, let’s focus on what happens when your SMLLC is considered a disregarded entity.
Disregarded Entities and Federal Taxes
When your SMLLC is a disregarded entity, it’s treated like any other sole proprietorship for federal tax purposes. This means that you’ll file IRS Schedule C, along with your personal tax return, in order to report all of your LLC’s income and expenses.
Any profits or losses that your business incurs are passed to your personal Form 1040, and added to any other income that you earn. Then, you pay tax on your profits at your personal income tax rates.
When you file your taxes as a disregarded entity, you’re entitled to the same tax deductions as any other business. That means you can write off things, like mileage, office expenses, software, travel, and other business expenses.
Plus, you also qualify for the pass-through deduction that took effect in 2018. With this deduction, you can write off up to 20% of your net business income from your income taxes.
Disregarded Entities and California State Taxes
If you’re doing business in California, the state will treat your SMLLC as a disregarded entity for tax purposes too. Again, this means that you’re treated as a sole proprietor for state taxes, just like you are for federal taxes.
All California LLCs are also required to file, with the Franchise Tax Board, a separate tax return on Form 568, Limited Liability Company Return of Income. The Franchise Tax Board uses this return to ensure you’ve paid your LLC tax and fee for the year.
For all other non-tax purposes, an SMLLC is treated as an LLC.
What does this mean?
Well, forming an SMLLC gives you limited liability for business debts, even though it’s a disregarded entity for tax purposes. On top of that, you need to comply with all of California’s rules for LLCs, including filing your statement of information with the California Secretary of State every other year.
And you should sign all contracts on behalf of your LLC using the SMLLC’s name rather than your personal name.
Changing Your SMLLC’s Tax Treatment
There isn’t anything wrong with being a disregarded entity and being taxed like a sole proprietor when you own an SMLLC.
But, if you decide that you’d rather be taxed differently, you have some options: You can choose to be taxed as an S Corp or a C Corp.
How do you change your tax treatment?
Start by making an election to receive corporation tax treatment with the IRS.
To have your SMLLC taxed like a C Corp: check the appropriate box on IRS Form 8832, Entity Classification Election, and file that with the IRS. The election can be completed at any time. Then, once the form is filed, you’ll be treated like a C corporation, and California will also recognize the change for state tax purposes.
To be taxed like an S Corp: file an S Corp election using IRS Form 2553.
Choosing C Corp Status
Here’s what you can expect when you opt to be taxed like a C Corp:
- You’ll create a separate taxpaying entity. The C Corp will be taxed separately from you, the business owner.
- The C Corp is allowed to deduct its business expenses.
- The C Corp must pay income taxes on its net income at the corporation tax rate. It also files its own tax return with the IRS using Form 1120 or Form 1120-A.
- You’ll pay personal income tax on C Corp income only when it’s distributed to you in the form of salary, bonuses, or dividends.
As of 2018, the tax rate for regular C Corps was reduced to a flat rate of 21%, thanks to the Tax Cuts and Jobs Act.
The corporate tax rate is substantially lower than the income tax rates paid by higher-income individuals, which can be as high as 37%.
However, this doesn’t necessarily mean that you’ll save on taxes by choosing to be taxed as a C Corp.
With a C Corp, you’ll be subject to double taxation.
Direct payment of your business profits to you is considered a dividend by the IRS and taxed twice. First, the business pays income tax on its profit at a 21% corporate rate. Then you pay personal income tax on salary or dividends you receive from your SMLLC.
C Corp dividends are usually taxed at capital gains rates.
Tax rates on dividends range from 15% to 23.8% for high-income taxpayers.
Higher-income taxpayers are also required to pay a 3.8% Medicare tax on net dividend and investment income. For example, if you pay tax on your corporation’s dividends at the 15% rate, the total tax on every $100 distributed to you will amount to $32.85.
The effective tax rate is 32.85%, which is higher than taxpayers in all but the top two individual income tax brackets: 21% corporate tax rate + (79% x 15% capital gains rate).
And keep in mind that dividend payments aren’t deductible by the corporation.
C Corp Dividends Capital Gains Rates
When you factor in the loss of this deduction, C Corp tax treatment becomes even less desirable if you’re hoping to save money. You won’t qualify for the new pass-through deduction.
But, if you earn more than $415,000 if you’re filing jointly or $207,500 if you’re single in profit from your business every year, C Corp taxation may benefit you. , This is especially true if you’re a service business because, at these income levels, service businesses can’t use the pass-through deduction.
And if you keep a substantial amount of income in your business by not distributing it to yourself as compensation or dividends, the money that you keep in the business is just taxed once at the 21% rate.
Choosing S Corp Status
Unlike a C Corp, an S Corp is a pass-through entity. That means that income and losses pass through the corporation to you, the owner, and your personal tax return. You pay taxes on the profits at your personal tax rate.
This is similar to how a sole proprietorship is treated for taxes.
But, when the owner of an SMLLC chooses S Corp status, they work as an employee of their business. This is different from SMLLCs taxed like sole proprietors, who aren’t allowed to be employees of their business.
When you’re taxed like a sole proprietorship, all of the profit from your business is subject to self-employment taxes. But, when you’re taxed like an S Corp, you’ll be an employee of your business and earn W-2 wages. The same 15.3% tax is paid only on your employee wages. You’ll pay half of the tax from your employee compensation, while the SMLLC will pay the other half.
S Corp tax treatment means you take home some money without paying taxes.
You’ll report your business’s earnings on your personal tax return and pay Social Security and Medicare taxes on your employee wages.
But you don’t have to pay Social Security or Medicare tax on distributions, which are the net profits that pass through to you from your business.
In the end, the larger your distribution, the less Social Security and Medicare taxes you’ll end up paying.
Let’s say that you took no salary. In that case, you wouldn’t owe any Social Security or Medicare taxes. But, this is a big no-no. The IRS requires that you’re paid a reasonable salary that’s at least equal to what other businesses pay for similar services.
How much tax you save with S Corp tax treatment depends on how much your business earns.
It really isn’t worth forming an S Corp when you’re net income is lower because you’ll have extra costs with S Corp treatment. This Includes paying a 1.5% California tax on your profits, in addition to a minimum annual franchise tax of $800.
Disregarded Entities and Taxation: A Lot to Consider!
The best way to know whether a specific tax treatment is right for your business is by crunching some numbers. Have an accountant help you, if necessary.
You can also join Collective for expert guidance when it comes to launching and maintaining your business. Click here to see how much Collective can save you on your taxes.
Stephen has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.