LLCs do not have a required tax classification. They are taxed using the tax system that applies to other entity types and can choose which tax classification to apply. Therefore, an LLC may be taxed as a sole proprietorship, partnership, C corporation, or S corporation, depending on the number of owners and their goals.
By default, a single member LLC is taxed as an entity disregarded as separate from its owner (a sole proprietorship), while multiple owner companies are taxed as a partnership, by default. Based on the ownership structure and the type, the LLC pays income tax differently.
The owner of an LLC is referred to as a member. If an LLC has one member, it’s known as single-member LLC. Apart from individual members, the LLC can be owned by a corporation, an S-Corporation, a trust, and another LLC.
In the United States, LLCs are classified as “pass-through” entities for tax reasons, meaning the business profits and losses will flow through to the personal tax return of each member. An LLC can also elect to be taxed as an S-Corporation or a C-Corporation. To be taxed as an S-Corporation, the LLC will have to file IRS form 2553. To be taxed as C-Corporation, the LLC is expected to complete IRS form 8832.
However, most LLCs are formed specifically to avoid being taxed as a C corporation. If there is a specific and compelling reason for a business to be taxed as a C corporation—for example, if the business is a high-growth start-up—then the business will more or less be organized as a corporation instead of an LLC, eliminating the need to consider whether an LLC should be taxed as a C corporation.
Since there is rarely a reason for an LLC to be taxed as a C corporation, the only choice is whether the LLC should accept the default classification or elect to be taxed as an S Corporation. In a nutshell, the choice is usually between the default classifications—either disregarded entity or partnership, depending on whether there are multiple owners—or electing to be taxed as an S corporation to save self-employment taxes.
Benefits of Accepting the LLC Default Classification
Although both the default classification and S corporation classification avoid double taxation, the default classification tends to offer various benefits over S corporation classification.
The Default Classification Doesn’t Include Eligibility Requirements
To be taxed as an S corporation, LLCs are expected to meet the eligibility requirements of subchapter S of the Internal Revenue Code. These requirements include:
- Owner Eligibility. All LLC owners are expected to be individuals, decedents’ estates, bankruptcy estates, certain types of trusts, or charitable organizations. If a corporation or partnership will own part of the LLC, for instance, the LLC is not eligible to elect to be taxed as an S corporation.
- Citizenship Requirements. If an owner is not a U.S. citizen and does not pass one of the two tests to be considered a resident alien, the LLC is not eligible to make a subchapter S election. The same is true if an owner’s spouse is a non-resident alien that is considered to own an interest in the LLC under community property law or other state law.
- Limited Number of Owners. Subchapter S also mandates the LLC to have no more than 100 owners, each of whom will have to consent to the subchapter S election. If the LLC will have more than 100 owners, or if any of the owners refuse to consent to the subchapter S election, then the LLC may not elect to be taxed as an S corporation.
- One Class of Equity. Note that the LLC can only issue one class of equity. Although differences in voting rights are allowed, the economic rights of the owners must be identical. This rule prohibits the use of liquidation or distribution preferences and incentive equity.
Have it in mind that the default classification avoids these requirements. LLCs that are disregarded for tax purposes or taxed as partnerships can have any number or type of owners and can issue multiple classes of equity. The absence of eligibility requirements makes the default classification much more flexible than the S corporation classification.
The Default Classification Makes It Easier to Capitalize the Business
When establishing a new business, the founders will often transfer money or property to the business as operating capital. Most times —especially in the real estate context—the owners may wish to transfer appreciated property to the business.
Note that the contribution of appreciated property to a business can create tax problems. If not handled correctly, the contribution could be treated as a sale to the business, resulting in taxable gain to the owner that contributes the property.
To avoid paying tax on a contribution of property, the LLC is expected to select a tax classification that does not tax built-in gain when a property is contributed to the LLC. The default classification rules make this easy. Irrespective of whether the LLC is a multi-member LLC taxed as a partnership or a single-member LLC that is disregarded for tax purposes, contributions of property to the LLC are not taxable events.
Once the LLC elects to be taxed as an S corporation, things become more complicated. A contribution of property to an S corporation is treated as a taxable sale unless, immediately after the contribution, all of the owners that contributed property “control” the business. Note that this control requirement makes it more challenging for owners to contribute property after the business is formed, especially if the owner contributing the property owns less than 80 percent of the company.
The Default Classification Allows LLCs to Make Tax-Free Distributions of Property
LLCs may distribute company property to an owner. If the property is appreciated, it is necessary for the LLC’s tax classification to treat the distribution as a tax-free transfer. An LLC taxed as a partnership may distribute property to the owners with no immediate tax consequence. Note that neither the LLC nor the owner is taxed on the transfer.
However, if the LLC is taxed as an S corporation, the Internal Revenue Code treats the LLC’s transfer of property to the owner as a taxable sale. All gains resulting from the deemed sale are taxed to the owner.
The Default Classification Taxes Pre-Contribution Gain to the Contributing Owner
Have it in mind that the contribution of appreciated property to a business can also create tax issues between founders. The partnership tax rules ensure that the owner that contributes appreciated property is ultimately taxed on the appreciation.
Note that when the partnership sells the property, the owner that contributed the property is taxed on the built-in gain. This rule protects the other owners from being unfairly taxed on the built-in gain that accrued before the property was contributed to the business.
The S corporation rules include no such protection. Once an owner contributes appreciated property to an LLC taxed as an S corporation, and the LLC later sells the property, each owner is expected to pay a portion of the tax on that gain.
That is indeed true even though the gain relates to the period before the owner contributed the property to the LLC. While this is beneficial to the owner that contributed the appreciated property, it is usually unfair to the non-contributing owners.
The Default Classification Allows LLCs to Use Incentive Equity
Incentive equity is equity offered to service providers as part of their compensation. Founders more or less use incentive equity to attract, retain, and motivate key employees. The ability to issue incentive equity is often a major factor in the growth of a business.
Corporations that issue incentive equity often leverage incentive stock options, non-qualified stock options, or restricted stock as incentives for their employees. LLCs do not issue stock, but LLC membership interests (equity in the LLC) can be structured to incentivize employees.
Note that the most common form of incentive equity for LLCs is a profits interest. A profits interest gives the holder the right to share in the LLC’s future growth, but no right to the entity’s assets at the time that the interest is granted. Howbeit, as long as the LLC is taxed under the default classification as a partnership, it can issue profits interests as incentive equity.
In the United States, the ability to issue profits interests is lost if the LLC is taxed as an S corporation. Since LLCs taxed as S corporations cannot issue classes of equity with different economic rights, they may not establish special classes of incentive equity to motive and retain key employees.
The Default Classification Allows the LLC to Issue Different Classes of Equity
A good number of businesses use preferred classes of equity to give some owners different economic rights than other owners. For instance, one investor may decide to contribute most of the operating capital to the business and want to recoup that investment before distributions are made to the other owners.
LLCs that are taxed under the default classification can issue equity (membership interests) with different economic rights. The operating agreement may establish a class of preferred equity with distribution or liquidation preferences that give the holders of those equity different economic rights from other owners. Note that the ability to establish classes of equity with different economic rights allows the LLC to accommodate most business deals between the owners.
However, LLCs taxed as S corporations cannot issue multiple classes of equity. Although differences in voting rights are allowed, each owner is expected to have identical economic rights. The LLC cannot issue preferred or incentive equity.
Instead, the LLC will be expected to distribute all earnings among the owners in proportion to their interests in the LLC. Even if one owner contributes most of the capital, that owner cannot recoup his or her investment more quickly than the non-contributing owners, and this restriction frustrates many common business arrangements.
The Default Classification Provides Basis Planning Opportunities
Founders can indeed benefit from an LLC tax classification that offers opportunities to grow basis. A higher basis allows owners to shelter more income, take higher deductions, and save taxes on the sale of equity in the business. LLCs taxed as partnerships have three basic advantages over LLCs taxed as S corporations:
- Note that when an LLC taxed as a partnership redeems the ownership interest of an owner, the remaining owners can get an increased basis in the LLC’s assets (inside basis step-up). This inside basis step-up allows the remaining owners to save taxes when partnership assets are sold. If the LLC is taxed as an S corporation, there is no increase to the LLCs inside basis in its assets on the redemption of an owner.
- Increased Basis for LLC Debt. The default partnership classification that applies to LLCs with multiple owners allows the owners to include LLC debt in the basis of their ownership interests (outside basis). Note that this basis increase lets the owner to deduct losses in excess of the owner’s capital investment. This benefit is not available if the LLC is taxed as an S corporation.
- Increased Basis on Sale of Equity. Once a buyer acquires an interest in an LLC taxed under the default classification, the buyer can step up the basis of the partnership’s assets (assuming, in the case of LLCs taxed as partnerships that a 754 election is in place). Indeed the value of the basis step-up can be separately modeled and added to the purchase price. If the company is lucrative, this increase makes the business more attractive to a buyer and has real economic value to the seller.
These benefits let the owners of LLCs taxed as partnerships to increase both inside basis and outside basis, placing them in a better tax position than owners of LLCs taxed as S corporations.
The Default Classification Allows LLCs to Make Special Allocations
An LLC’s income, deduction, and related tax items are divided among the owners through a process known as allocation. By default, LLC allocations occur in proportion to the owner’s interest. For instance, if Owner A has a 75 percent interest in the LLC and Owner B has a 25 percent interest in the LLC, then Owner A is taxed on 75 percent of the income, and Owner B is taxed on 25 percent of the income.
However, if the LLC is taxed as a partnership, the owners can change the default allocations by making special allocations that distribute income tax items disproportionately among the members. Note that this flexibility is lost once the LLC elects to be taxed as an S corporation. The S corporation rules require all income, loss, and other tax items to be allocated among the owners on a pro rata basis.
LLC owners can decide the tax classification with the most benefits to them. The choice is more or less between the default classifications—either disregarded entity or partnership, depending on whether there are multiple owners—or electing to be taxed as an S corporation to save self-employment taxes. The owners of the LLC should make the appropriate decision for the tax classification of the LLC based on the tax benefits and savings that the business may be able to enjoy.