Whenever you establish a business, it will receive a form of tax treatment by default. This happens automatically. However, except for sole proprietorships, business entities do have some leeway when it comes to changing their default treatment to another type.
What’s the default tax treatment that you can expect for a single-member LLC (SMLLC)? The answer is “disregarded entity,” which is basically just a fancy way of saying that the IRS pretends that the LLC doesn’t exist. It means that the owner of the SMLLC will be taxed like a sole proprietorship would. (A sole proprietorship is a one-owner business that’s personally owned by the proprietor, so 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. Bear in mind that, although we’ve made every effort to ensure that this information is up-to-date and accurate, it doesn’t constitute legal advice, and it shouldn’t be used as a substitute for legal or tax advice, so consult with your attorney or tax advisor if you have any questions or need guidance regarding your business.
Disregarded Entities and Federal Taxes
When your SMLLC is a disregarded entity, it will be 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 the income and expenses that your LLC has incurred over the past year.
Any profits or losses that your business incurs are passed to your personal Form 1040, and they’re added to any other income that you earn. Therefore, you pay tax on your profits at your personal income tax rates.
When you file your taxes in this manner, you’re also entitled to the same tax deductions as any other business, including things like mileage, office expenses, and various business expenses.
Plus, you can now also qualify for the new 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. Very helpful!
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 as well. Again, this means that you’re treated as a sole proprietor for state taxes, just as 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 will use this return to ensure you’ve paid your LLC tax and fee for the year.
For all other non-tax purposes, an SMLLC will be treated like an LLC rather than as a disregarded entity.
What does this mean? Well, the SMLLC provides you with 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, which include filing statements 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 necessarily wrong with being considered a disregarded entity and being taxed like a sole proprietor when you own an SMLLC. But if you do decide that you’d rather be taxed differently, you have some choices that you can consider; namely, you can choose to be taxed as an S corporation or a C corporation.
How do you change your tax treatment? Start by making an election to receive corporation tax treatment with the IRS.
In order to have your SMLLC taxed like a C corporation, simply 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. Once the form is filed, you’ll be treated like a C corporation, and California will also recognize the change for state tax purposes.
On the other hand, if you want to be taxed like an S corporation, you can do so by filing an S corporation election using IRS Form 2553. Easy enough, right?
Choosing C Corporation Status
Here’s what you can expect when you opt to be taxed like a C corporation:
- You’ll be creating a separate taxpaying entity. The C corporation will be taxed separately from you, the business owner.
- The C corporation will be entitled to deduct its business expenses.
- The C corporation must pay income taxes on its net income at the C corporation tax rate. It must also file its own tax return with the IRS using Form 1120 or Form 1120-A.
- You’ll pay personal income tax on C corporation income only when it’s distributed to you in the form of salary, bonuses, or dividends.
- Starting in 2018, the tax rate for regular C corporations will be reduced from a top rate of 35% to a flat rate of 21% on all C corporation income, 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 corporation, so keep that in mind as you ponder your options.
- You’ll need to deal with double taxation because any direct payment of your business profits to you will be considered a dividend by the IRS and, therefore, taxed twice. First, the business will pay income tax on the profit at a 21% corporate rate on its own return. Then you’ll pay your personal income tax on what you receive from your SMLLC.
- C corporation dividends will usually be taxed at capital gains rates, and tax rates on dividends range from 15-23.8% for high income taxpayers. Higher income taxpayers are also required to pay a 3.8% Medicare tax on net dividend and investment income. So, 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). Keep in mind that dividend payments aren’t deductible by the corporation.
|Income: Married Filing Jointly||Income: Individual||Individual Income Tax on Business Income||Combined Tax on C Corp. Distributions (21% C corporation tax + dividend tax)|
|$0 – $19,050||$0 – $9,525||10%||21%|
|$19,050- $77,400||$9,525 – $38,700||12%||21%|
|$77,400 – $165,000||$38,700 – $82,500||22%||32.85%|
|$165,000 – $315,000||$82,500 – $157,500||24%||32.85%|
|$315,000 – $400,000||$157,500 – $200,000||32%||32.85%|
|$400,000 – $600,000||$200,000 – $500,000||35%||32.85%|
|over $600,000||over $500,000||37%||39.80%|
- You won’t qualify for the new pass-through deduction that’s discussed above. When you factor in the loss of this deduction, C corporation tax treatment becomes even less desirable if you’re hoping to save money.
- If you’re earning over $415,000 ($207,500 if you’re single) in profit from your business annually, being taxed in this manner might benefit you, particularly if you’re in a service business because, at these income levels, service businesses can’t use the pass-through deduction.
- If you’re able to 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 will be taxed once at the 21% rate.
Choosing S Corporation Status
Unlike a C corporation, an S corporation is a pass-through entity, which means that income and losses pass through the corporation to you, the owner, and your personal tax return, with profits taxed at your personal tax rate. Therefore, this is similar to how a sole proprietorship is treated for taxes.
However, when the owner of an SMLLC chooses S corporation status, they’ll ordinarily work as an employee of that business, while owners of SMLLCs that are taxed like sole proprietors aren’t employees of the SMLLC.
Things to consider if you’re thinking about being taxed as an S corporation:
- You can save money on Social Security and Medicare tax (also known as self-employment taxes) because this is a flat 15.3% tax on your first $128,400 in income, in 2018. If you earn more, you’ll also pay a 2.9% tax on your income up to $200,000 if you’re single or $250,000 if you’re married filing jointly. The taxable income ceiling is adjusted annually for inflation, so keep that in mind. Also, all employee wages or net self-employment income over these amounts is subject to a 3.8% Medicare tax.
- When you’re taxed like a sole proprietorship, all of the income that you receive from your business will be subject to self-employment taxes, but if you’re being treated like a C corporation, you’ll be an employee of your business, and the same 15.3% tax must be paid. You’ll pay half of the tax from your employee compensation, while the SMLLC will pay the other half.
- S corporation tax treatment offers a means to take home some money without paying these taxes. You’ll report your business’s earnings on your personal tax return, and you’ll pay Social Security and Medicare taxes on any employee salary that your SMLLC pays you. But you don’t have to pay such tax on distributions (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 that you’ll end up paying.
- Let’s say that you took no salary at all for yourself. In that case, you wouldn’t owe any Social Security or Medicare taxes. This, however, isn’t allowed, as the IRS requires that you be paid a reasonable salary that’s at least equal to what other businesses pay for similar services.
To sum everything up: the amount of Social Security and Medicare tax that you’ll save with an S corporation tax treatment will depend upon how much money your business earns. It simply isn’t worth going through forming an S corporation to save on these taxes at lower income levels because you’ll have extra costs with S corporation treatment (including having to pay 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. And you can also sign up with Hyke for expert guidance when it comes to launching and maintaining your business. Join us today to learn about how we can help you manage your LLC, make informed decisions of the right way to be taxed, and pay all of your taxes on time.
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.