Is an LLC Double Taxed? How Tax Elections Affect Your LLC

A Limited Liability Company (LLC) is a business structure that combines the limited liability protection of a corporation with the pass-through taxation of a partnership or sole proprietorship. A common concern for those considering this structure is whether an LLC is subject to “double taxation,” a scenario where business profits are taxed once at the company level and again when distributed to owners. Understanding how LLCs are taxed, both by default and through elective classifications, is important for business owners.

Understanding Default LLC Taxation

By default, the Internal Revenue Service (IRS) classifies an LLC as a pass-through entity for federal income tax purposes. This means the business itself does not pay federal income tax. Instead, the profits and losses of the LLC are “passed through” directly to the owners, who then report these amounts on their individual income tax returns. This structure avoids the issue of double taxation.

For a single-member LLC, the business is treated as a “disregarded entity,” similar to a sole proprietorship. The owner reports all business income and expenses on Schedule C (Form 1040), Profit or Loss from Business, as part of their personal tax return. This direct reporting ensures that income is taxed only once at the individual owner’s tax rate.

For a multi-member LLC, the business is treated as a partnership. The LLC files an informational return, Form 1065, U.S. Return of Partnership Income, to report its income, deductions, gains, and losses. However, the LLC itself does not pay income tax. Instead, each member receives a Schedule K-1 detailing their share of the LLC’s profits or losses. Members then report this income on their personal tax returns, ensuring that the income is taxed only once at the individual level.

This default pass-through taxation is a significant advantage for many LLCs, as it eliminates the second layer of tax that can occur with traditional corporate structures. Owners pay self-employment taxes (Social Security and Medicare taxes) on their share of the business’s net earnings. This direct flow of income and expenses to the owner’s personal tax return is the primary reason an LLC, under its default classification, is not double-taxed.

Electing a Corporate Tax Classification

While an LLC is typically a pass-through entity, it possesses the flexibility to elect to be taxed as a corporation for federal income tax purposes. This choice allows an LLC to adopt a tax structure that might offer different advantages or disadvantages depending on the business’s specific circumstances. The election changes how the LLC’s income is treated for federal tax purposes, moving it away from the default pass-through method.

Taxed as a C Corporation

If an LLC elects to be taxed as a C corporation, it will be subject to double taxation. In this structure, the business itself is a separate tax-paying entity. The C corporation pays federal income tax on its profits at the corporate tax rate. After the corporation pays taxes on its earnings, any remaining profits distributed to shareholders as dividends are then taxed again at the individual shareholder level.

For example, if a C corporation earns profits and distributes them to its owners, the profits are first taxed at the corporate level. The dividends received by the individual shareholders are then subject to individual income tax rates. This dual taxation of corporate earnings—once at the corporate level and again at the individual shareholder level—is the defining characteristic of C corporation taxation.

Taxed as an S Corporation

An LLC can also elect to be taxed as an S corporation, a classification that generally avoids double taxation. An S corporation is a pass-through entity for federal income tax purposes. This means that the corporation’s income, losses, deductions, and credits are passed directly to the shareholders’ personal tax returns, where they are taxed at individual income tax rates.

A key distinction for an S corporation, particularly for owner-employees, is the requirement to pay a reasonable salary. This salary is subject to payroll taxes (Social Security and Medicare). Any remaining profits after paying the reasonable salary can be distributed to owners as tax-free distributions, as long as the distribution does not exceed the owner’s basis in their stock. This structure allows for potential self-employment tax savings on distributions, as these are not subject to Social Security and Medicare taxes, unlike the entire net earnings of a default LLC.

To qualify for S corporation status, an LLC must meet specific IRS requirements. These include being a domestic entity, having no more than 100 shareholders, and having only one class of stock. Shareholders must generally be individuals who are U.S. citizens or residents, certain trusts, or estates. Partnerships, corporations, and non-resident aliens typically cannot be S corporation shareholders.

The Process for Changing Tax Classification

Changing an LLC’s tax classification for federal purposes involves submitting specific forms to the Internal Revenue Service. These forms require detailed information about the entity and its owners.

To elect taxation as a C corporation, an LLC files Form 8832, Entity Classification Election. This form requires the entity’s name, Employer Identification Number (EIN), and the effective date of the election. The effective date can generally be no more than 75 days before the form is filed and no more than 12 months after the filing date. The completed Form 8832 should be mailed to the IRS service center corresponding to the business’s location.

For an LLC electing S corporation status, Form 2553, Election by a Small Business Corporation, must be filed. This form requires the LLC’s name, EIN, and the desired effective date. All shareholders must consent to the election and sign the form. Form 2553 generally must be filed no later than two months and 15 days after the beginning of the tax year the election is to take effect. If the deadline is missed, there may be provisions for late election relief, but the form cannot be filed electronically; it must be mailed or faxed to the appropriate IRS service center.