When Are LLCs Considered Disregarded Entities?

A Limited Liability Company (LLC) is a business structure created under state law that offers liability protection to its owners, who are called members. For federal income tax purposes, the Internal Revenue Service (IRS) may treat an LLC in several ways, with one of the most common classifications being a “disregarded entity.” A disregarded entity is a business that is separate from its owner for liability purposes but not for federal income tax purposes. The IRS ignores the business’s separate existence for tax reporting, taxing its activities directly on the owner’s personal tax return. This approach simplifies tax filing for many small business owners while still providing the asset protection benefits that make LLCs an attractive option.

Default Federal Tax Classifications for LLCs

The number of members in an LLC is the primary factor that determines its default tax classification. An LLC with only one member is, by default, treated as a disregarded entity, and the LLC itself does not file a separate federal income tax return. For an individual who owns a single-member LLC, all the business’s income and expenses are reported on their personal tax return, Form 1040. This is accomplished by attaching Schedule C, “Profit or Loss from Business,” which is the same form used by sole proprietors. All net profits on Schedule C are subject to both regular income tax and self-employment taxes, which cover Social Security and Medicare contributions.

An LLC with two or more members receives a different default classification. The IRS automatically treats a multi-member LLC as a partnership for federal tax purposes. A partnership is required to file an annual informational tax return, Form 1065, “U.S. Return of Partnership Income,” which reports the LLC’s total income, deductions, gains, and losses.

The LLC itself does not pay income tax; instead, the profits and losses are “passed through” to the members. The LLC provides each member with a Schedule K-1, which details their share of the partnership’s financial results. Each member then uses the information from their Schedule K-1 to report their portion of the income or loss on their personal Form 1040, typically on Schedule E.

Electing an Alternative Tax Status

An LLC is not permanently bound by its default tax classification. Business owners can elect for their LLC to be taxed as a corporation if it better suits their financial strategy. This election changes how the business’s profits are taxed but does not alter its legal structure as an LLC under state law. There are two corporate tax treatments an LLC can choose: a C Corporation or an S Corporation.

Choosing to be taxed as a C Corporation means the LLC is treated as a separate taxpayer from its owners. The business must file its own corporate income tax return, Form 1120, and pay tax on its profits at the corporate rate. If the company distributes after-tax profits to members as dividends, those dividends are taxed again on the members’ personal returns, creating “double taxation.”

Alternatively, an LLC can elect to be taxed as an S Corporation. Like a partnership, an S Corporation is a pass-through entity and does not pay federal income tax at the business level. The LLC files an informational return, Form 1120-S, and profits pass through to the members. A distinction for S Corporations is how owner-employees are compensated. They must be paid a “reasonable salary,” which is subject to payroll taxes, while any remaining profits can be distributed as dividends, which are not subject to self-employment taxes, potentially offering tax savings.

How to Make a Tax Classification Election

To change its tax status to a corporation, an LLC must file a specific form with the IRS. If an LLC wishes to be taxed as a C Corporation, it must file Form 8832, “Entity Classification Election.” This form requires basic information about the LLC, including its name, address, and Employer Identification Number (EIN). The form must also be signed by each member or an authorized officer to show consent for the change.

The new classification cannot take effect more than 75 days before the date the election is filed, nor can it take effect more than 12 months after the filing date. Once an election is made, an entity cannot change its classification again for 60 months (five years).

For an LLC to be taxed as an S Corporation, it must file Form 2553, “Election by a Small Business Corporation.” This form requires shareholder consent and the desired effective date of the election. To be effective for the current tax year, the form must be filed no more than two months and 15 days after the beginning of that tax year. For a new business, this window starts on its date of formation.

If the deadline is missed, the S Corporation status will not take effect until the following tax year, unless the business can show reasonable cause for the late filing.

State Tax Treatment Considerations

An LLC’s federal tax classification does not always dictate its treatment at the state level. While many states conform to the IRS’s “disregarded entity” status, others impose their own entity-level taxes and filing requirements regardless of the federal classification.

These state-level obligations can take various forms. Some states impose an annual franchise tax, which is a fee for the privilege of doing business in that state. This tax may be a flat amount, such as an $800 annual tax, or it could be calculated based on the business’s revenue or net worth. Other states levy a gross receipts tax or a margin tax on business entities, including LLCs.

Because of these variations, it is important for LLC owners to look beyond federal rules. They must investigate the specific requirements of their state’s tax authority to ensure full compliance. Failure to pay state-level LLC taxes or file required reports can lead to penalties and could jeopardize the LLC’s good standing with the state.