When Do LLCs Get Double Taxed? An Explanation

Limited Liability Companies (LLCs) are a favored business structure in the United States. They offer owners liability protection, similar to a corporation, combined with operational and tax flexibility. LLCs shield personal assets from business debts and liabilities, providing a layer of security. This structure simplifies management compared to traditional corporations, appealing to many entrepreneurs. The flexibility of an LLC extends to its federal income tax treatment.

How LLCs Are Typically Taxed (Avoiding Double Taxation)

By default, the Internal Revenue Service (IRS) treats LLCs as “pass-through” entities for federal income tax purposes. This means the business itself does not pay corporate income tax. Instead, the LLC’s profits and losses are directly passed through to the owner(s), who report these amounts on their personal income tax returns. This pass-through taxation avoids the “double taxation” scenario often associated with traditional C corporations, where income is taxed at both the business and owner levels.

The default tax classification for an LLC depends on the number of owners, or members. A single-member LLC is automatically classified as a “disregarded entity” by the IRS, treated as a sole proprietorship for tax purposes. The owner reports all business income and expenses on Schedule C (Form 1040), filed with their individual income tax return. All profits are subject to self-employment taxes, covering Social Security and Medicare contributions.

When an LLC has two or more members, it is classified as a partnership for federal tax purposes by default. The LLC does not pay income tax at the entity level. Instead, the partnership files an informational return with the IRS, Form 1065, “U.S. Return of Partnership Income,” reporting its overall income, deductions, and other financial information.

Each member of a multi-member LLC receives a Schedule K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.” This document details their share of the partnership’s income, losses, deductions, and credits. Members use this information to report their shares on their personal income tax returns (Form 1040). Profits allocated to each member are subject to self-employment taxes.

Electing Different Tax Classifications

While LLCs have default tax classifications, they offer flexibility, allowing owners to elect how their entity will be taxed for federal income tax purposes. This election is made by filing specific forms with the IRS. Owners can choose to have their LLC taxed as either an S corporation or a C corporation, rather than the default sole proprietorship or partnership classification.

A common election is to be taxed as an S corporation, made by filing Form 2553, “Election by a Small Business Corporation.” The motivation for electing S corporation status often involves potential savings on self-employment taxes for active owner-employees. S corporations are pass-through entities, meaning income and losses are reported on the owners’ personal tax returns. Active owners can divide their compensation into a reasonable salary and distributions; the salary portion is subject to payroll taxes, but distributions are not, potentially reducing the self-employment tax burden.

The S corporation election maintains the pass-through taxation principle; the business itself does not pay federal income tax. Profits and losses are passed through to the shareholders and taxed only at the individual level. However, the IRS requires owner-employees to receive “reasonable compensation” for services performed, paid as wages subject to payroll taxes. This prevents owners from classifying too much income as distributions to avoid self-employment taxes.

Alternatively, an LLC can elect to be taxed as a C corporation by filing Form 8832, “Entity Classification Election.” Although less common for small businesses due to double taxation implications, specific reasons exist for choosing C corporation status. These include attracting venture capital or outside investors, as C corporations have a more familiar structure for equity investments.

Other motivations for electing C corporation status include offering certain tax-advantaged fringe benefits to employees, deductible by the corporation. A C corporation also allows for the retention of earnings within the business for reinvestment or growth without immediate individual taxation. Electing C corporation status means the LLC is treated as a separate legal entity for tax purposes, subject to corporate income tax on its profits, setting the stage for double taxation.

Implications of Electing C Corporation Status

An LLC electing to be taxed as a C corporation is the scenario where double taxation can occur. This distinct tax treatment fundamentally alters how the business’s profits are handled for federal income tax purposes. The business, operating as a C corporation for tax purposes, becomes a separate taxable entity from its owners.

Double taxation arises because the C corporation’s profits are taxed at two distinct levels. The first level of taxation occurs when the LLC, classified as a C corporation, pays corporate income tax on its net profits. This corporate tax is levied directly on the business’s earnings before any distributions are made to shareholders.

The second level of taxation occurs when the remaining after-tax profits are distributed to the owners, now considered shareholders, as dividends. These dividends are personal income to the shareholders and are taxed again at their individual income tax rates. This means the same dollar of profit is taxed once at the corporate level and again at the individual shareholder level when received as a dividend.