Can an LLC Really Choose How to Be Taxed? – Yes, But Avoid This Mistake + FAQs

Confused about how an LLC can be taxed? You’re not alone.

According to a 2023 National Small Business Association survey, over 40% of small business owners felt unsure about their LLC’s tax classification, potentially paying thousands more in taxes than necessary.

Can an LLC Choose How to Be Taxed?

Yes. Under U.S. federal law, a limited liability company (LLC) can choose how to be taxed. By default, the IRS does not tax an LLC as its own entity. Instead, the LLC’s income “passes through” to its owners’ tax returns. However, LLC owners have the flexibility to elect a different tax status if it benefits them. For example, an LLC can file a form to be taxed as an S corporation or even as a C corporation.

In other words, an LLC isn’t locked into one tax treatment. You can choose the tax classification that best fits your business’s needs, whether that’s the default pass-through setup or an alternative like S corp status. The key is understanding the options and following IRS rules to make the election properly.

LLC Tax Election Options

LLCs enjoy a “check-the-box” flexibility from the IRS, meaning you can literally check a box to pick how your LLC will be taxed. Here are the main tax election options available to LLCs:

Default Pass-Through Taxation (Sole Proprietorship or Partnership)

By default, the IRS ignores a single-member LLC as a separate entity for tax purposes. This is called being a “disregarded entity.” If you’re the sole owner, the LLC’s profits and losses simply go on your personal income tax return (usually on Schedule C). You pay income tax on the profit, and if you actively work in the business, you pay self-employment tax (15.3% for Social Security and Medicare) on that profit as well. Essentially, it’s taxed just like a sole proprietorship.

For an LLC with multiple owners (members), the default is taxation as a partnership. The LLC itself doesn’t pay income tax, but it must file an informational Partnership Return (Form 1065). The LLC provides each member a Schedule K-1 showing their share of profit or loss, which they report on their personal return. Each active member pays income tax (and typically self-employment tax) on their share of the LLC’s earnings.

Key point: Default LLC taxation means pass-through taxation. All profits pass through to owners to be taxed at individual rates. There’s no separate federal business income tax on the LLC itself. While simple, this also means owners shoulder the full tax burden, including self-employment taxes on all earnings.

Electing S Corporation Status

An LLC can choose to be taxed as an S corporation (S corp) by filing IRS Form 2553 (Election by a Small Business Corporation). An S corp is a special type of pass-through entity under the tax code. This election doesn’t change your company’s legal structure – your business is still an LLC – but for tax purposes it’s treated like an S corp.

Why elect S corp status? The primary reason is to potentially save on self-employment taxes. In an S corp, owner-shareholders who work in the business are considered employees for tax purposes. They must be paid a “reasonable salary” as W-2 wages. That salary is subject to Social Security and Medicare taxes (payroll taxes), split between the employee and employer. But any remaining profit (after paying that salary) can be taken as a distribution to the owner and is not subject to self-employment tax. It’s still taxed as ordinary income on the owner’s return, but it avoids the 15.3% tax on that portion.

For example, if your LLC earns $100,000 in profit and you elect S corp status, you might pay yourself a salary of $50,000. You’d pay Social Security/Medicare taxes on that $50k. The remaining $50k is distribution — you’d pay income tax on it, but no self-employment tax, potentially saving around $7,650 in taxes compared to the default LLC treatment (which would levy 15.3% on the entire $100k).

Important considerations: Not every LLC can elect S corp status. You must meet IRS requirements for S corps:

• U.S. only owners: All owners (members) must be U.S. citizens or residents.
• 100 or fewer owners: You can’t have more than 100 members.
• One class of ownership: You can’t have different classes of stock or membership interests that alter profit sharing (special allocations are not allowed).

If you meet these, you can file Form 2553. Timing matters too – generally you file by March 15 of the year you want S corp status to be effective (or within 75 days of forming the LLC or acquiring it). Late filings may be accepted with valid reason under IRS relief rules, but it’s best to file on time.

S corp election also means additional responsibilities:

• You must run payroll for any working owners (and other employees) to pay that salary and withhold taxes.
• You’ll file an S corporation tax return (Form 1120-S) each year, and give K-1s to owners for their shares of income (similar to a partnership’s process).
• Some fringe benefits (like certain health insurance or retirement plan contributions) have special rules in an S corp.

Despite a bit more paperwork, many LLC owners find the S corp election beneficial once their net profits grow beyond a certain point. (We’ll cover how to decide if S corp status makes sense in the Strategies section.)

Electing C Corporation Status

An LLC can also elect to be taxed as a C corporation (C corp) by filing IRS Form 8832 (Entity Classification Election). In this scenario, your LLC is treated like a regular corporation for tax purposes. C corps pay a flat 21% corporate income tax on their profits at the federal level (as of current law). If the corporation distributes profits to owners as dividends, those dividends are taxed again on the owners’ personal returns (typically at 15% or 20% capital gains tax rates). This is the infamous double taxation issue – profits can be taxed twice (once at the corporate level, once at the individual level when paid out).

Why would an LLC choose C corp taxation? There are a few situations:

• Reinvesting profits: If you plan to keep profits in the business for growth (rather than distribute them), the 21% corporate tax rate might be lower than your personal tax rate. The LLC (as a C corp) can retain after-tax earnings for expansion, and you defer personal tax until you take dividends.
• Specific deductions or benefits: C corps can deduct certain benefits fully (like health insurance for employees) and can have more flexibility in fringe benefits. They also aren’t subject to the same restrictions as S corps (for example, they can have foreign or numerous owners, multiple classes of stock, etc.).
• Attracting investors: Some investors (like venture capital firms) prefer investing in C corps. Also, C corp status might be necessary to qualify for certain stock incentives (like potential Section 1202 Qualified Small Business Stock exclusion on capital gains if you meet requirements by being a C corp for a certain period).

However, for small businesses, C corp taxation often results in higher overall taxes if all profits are taken out as salary and dividends. Typically, small LLCs avoid C corp status unless there’s a strategic reason, because any money you take out as dividends faces that second layer of tax. Note that if you work in the business, even a C-corp LLC can pay you a salary (which is deductible to the corporation and taxed once as your wage income).

Election process: To be taxed as a C corp, an LLC files Form 8832 and checks the box to be classified as an association (taxed as a corporation). You can do this at formation or later. If you had previously elected S corp and want to revert to C, you’d either revoke the S status or file Form 8832 as well. Keep in mind, once you change classification, IRS rules often require you to stick with it for at least five years before changing again (to prevent flipping back-and-forth to game the system).

Key Tax Terms for LLC Owners

Understanding the terminology is half the battle. Here are some key tax terms and concepts every LLC owner should know:

• Pass-through taxation: A tax regime where the business itself does not pay income tax. Instead, profits “pass through” to the owners’ personal tax returns and are taxed at individual rates. Default LLCs and S corps are pass-through entities.
• Disregarded entity: The tax status of a single-member LLC by default. The IRS “disregards” the entity, meaning it doesn’t file a separate business return – the owner reports all income on their own return.
• Self-employment tax: A 15.3% tax (comprised of Social Security and Medicare contributions) that self-employed individuals pay on business income. LLC members in a default tax setup are subject to this on their net earnings, since they’re considered self-employed.
• Form 1065: The U.S. Return of Partnership Income. Multi-member LLCs use this to report partnership income, deductions, and credits to the IRS. It’s informational – the tax is paid by members on their personal returns via K-1 forms.
• Schedule K-1: A tax form used by partnerships and S corps to report each owner’s share of the business’s income, deductions, and credits. If your LLC is taxed as a partnership or S corp, each member gets a K-1 for their personal filings.
• Form 1120-S: The annual tax return filed by an S corporation to report income and expenses. An LLC taxed as S corp files this instead of a partnership return or Schedule C.
• Form 8832: The Entity Classification Election form. LLCs submit this to the IRS to change their default classification (for example, to be taxed as a C corporation). Not needed for an S corp election (Form 2553 covers that), unless revoking a prior classification.
• Double taxation: Refers to C corporation taxation where income is taxed at the corporate level and then again at the shareholder level when distributed as dividends. Pass-through entities avoid this, as income is only taxed once on owners’ returns.
• Qualified Business Income (QBI) deduction: A 20% federal tax deduction introduced by the Tax Cuts and Jobs Act for pass-through business income (including LLC income from sole prop, partnership, or S corp). This deduction can reduce the taxable income from your LLC on your personal return, subject to various rules and limits.
• Reasonable compensation: An IRS requirement for S corp owner-employees. If your LLC is taxed as an S corp, any owner who works in the business must be paid a reasonable wage for their work before taking additional profit as distributions. This prevents avoiding too much self-employment tax by labeling all earnings as distributions.

Comparing Tax Scenarios: LLC vs S Corp vs C Corp

To make these options clearer, let’s compare the three common tax scenarios for an LLC. Below is an illustration of how taxes might work for a single-owner LLC earning $100,000 in profit under each classification:

In the above comparison, the S corp scenario saved the owner a substantial amount in self-employment taxes compared to default LLC (paying roughly $7,650 vs $15,300 in Social Security/Medicare taxes). The C corp scenario showed how double taxation can make overall taxes higher if all after-tax profits are distributed (about $32.85k total tax in C corp vs the S corp’s combination of personal tax plus payroll taxes, which would typically be lower depending on the owner’s tax bracket).

Every business’s numbers will differ, but this illustrates the core differences:

• Default LLC: One layer of tax (personal), but you pay self-employment tax on all profits.
• S Corp: One layer of tax (personal), and you can reduce the portion of profit subject to self-employment tax by paying yourself a reasonable salary and taking the rest as distributions.
• C Corp: Two layers of tax if profits are distributed. Potentially advantageous only if corporate profits are kept in the business or if personal tax rates are much higher than 21% and distributions are minimized.

7 Common Mistakes to Avoid in LLC Tax Elections

Choosing a tax status for your LLC can yield great benefits, but there are pitfalls to avoid. Here are some common mistakes LLC owners should steer clear of:

• Assuming an LLC automatically saves taxes: Simply forming an LLC doesn’t magically lower your taxes. By default, you might pay the exact same tax as a sole proprietor. Tax savings come from choosing the right tax election (like S corp) and strategy, not just the LLC itself.
• Electing S Corp status too early or with low profits: If your net business income is small (for example, $30,000), the savings from an S corp may be minor or nil, while the costs (payroll service, extra tax filings) and complexity are real. Wait until you have sufficient profit (many experts suggest at least around $50K+ in net earnings) before electing S corp, so the tax savings outweigh the extra overhead.
• Missing the S Corp election deadline: LLCs that want S corp taxation need to file Form 2553 on time (generally by March 15 of the tax year). Missing this deadline could mean you have to wait until next year for S status, or go through the hassle of requesting late election relief. Mark your calendar and file early to avoid this mistake.
• Not paying yourself a reasonable salary in an S Corp: If you do elect S corp, don’t try to game the system by paying yourself little to no salary to avoid payroll taxes. The IRS watches for unreasonable compensation. If you take too low a salary, you risk penalties and having all distributions reclassified as wages (negating the benefit). Always pay a fair, market-based salary to yourself as an owner-employee.
• Ignoring state-level taxes and fees: State tax treatment can differ from federal. For example, some states impose a franchise tax or LLC fee regardless of federal tax status (e.g., California charges an $800 annual LLC tax and additional fees on LLCs based on revenue, even if you’re an S corp for federal tax). Some states also require a separate S corp election filing at the state level, or they may not recognize the S corp status (which could lead to state taxes as if you were a C corp). Always check your state’s rules so that your election doesn’t lead to unexpected state taxes or compliance requirements.
• Frequent tax classification changes: While it’s possible to change your LLC’s tax status more than once, doing so too often can raise red flags and may be limited by the IRS. Once you elect a classification, you generally must stick with it for at least five years. Don’t flip back and forth annually; plan ahead and choose wisely the first time.
• Not consulting a professional: The tax implications of each option can get complex, especially as your business grows. One misstep (like an incorrect filing or misunderstanding of the rules) can cost you. It’s wise to consult a CPA or tax advisor when making a tax election for your LLC, to ensure you’re doing it correctly and to optimize the outcome.

7 Best Strategies for Choosing the Right Tax Status for Your LLC

Selecting the optimal tax strategy for your LLC depends on your unique situation. Here are some of the best strategies and considerations to help make the decision:

1. Start with the default, then adjust as you grow: New business owners can keep things simple initially with the default pass-through taxation. As your profits increase, reevaluate annually. Once your LLC is solidly profitable (for instance, crossing that $50K–$70K net income range), consider whether an S corp election would save on taxes. This way, you’re not incurring complexity before you benefit from it.
2. Weigh the tax savings against additional costs: Calculate the potential self-employment tax savings of an S corp versus the costs (payroll service fees, higher accounting costs, possibly a bit more admin burden). For example, if S corp status saves you $5,000 in taxes but costs $1,500 in extra expenses and hassle, it’s probably worth it. If it only saves $1,000 and costs $1,500, you might hold off.
3. Keep an eye on reasonable salary benchmarks: If you elect S corp, research what a reasonable salary for your role and industry would be. A good strategy is to pay yourself at least that amount to stay on the IRS’s good side, and take additional profit as distributions. There are tools and even IRS guidelines to help determine reasonable compensation. Document how you arrived at your salary figure in case of an IRS inquiry.
4. Consider future plans and investors: Think about your long-term plans. If you intend to seek venture capital or bring in many investors, staying a pass-through entity might not be ideal in the long run — some might prefer a C corp structure. On the other hand, if you’re a closely-held business with just a few owners, an S corp can be very efficient. Align your tax status with the future needs of the business.
5. Review state tax implications: As mentioned, each state has its own tax rules. A strategy that works federally could have drawbacks in your state. For instance, if you’re in a state that levies heavy fees on LLCs, you might evaluate whether switching to a corporation (while maintaining S corp status for tax) would lower state fees. Or if your state doesn’t recognize S corps, you may not get the full benefit at the state level. Include state taxes in your analysis of net savings.
6. Plan for earnings reinvestment vs. distribution: If you plan to reinvest most of your profits into growth (and not pay them out to yourself), a C corp taxation might yield a lower immediate tax bill, since you’d only pay the 21% corporate tax and could defer personal taxes. However, remember that eventually if you do distribute profits, the second tax hits. A balanced strategy for some companies is to use C corp status during high-growth phases when personal tax brackets are high and distributions are low, then switch to S corp or pass-through before starting to take significant dividends. This is a complex strategy that definitely requires professional guidance and understanding the IRS rules on timing of election changes.
7. Keep proper documentation and stay compliant: Whatever route you choose, treat it formally. If you’re an S corp, run payroll and keep corporate records. If a C corp, ensure you follow corporate formalities and filings. Being sloppy can undermine the benefits of your tax status or lead to penalties. Good record-keeping and compliance are part of a smart tax strategy.

Finally, remember that tax laws change. A strategy that’s optimal today might shift with new legislation (for example, changes in tax rates or rules for pass-through deductions). Stay informed or work with a tax professional to revisit your LLC’s tax setup periodically. The best strategy is one that is proactive and adapts to both your business’s growth and the ever-evolving tax landscape.

State Tax Nuances for LLCs

Federal tax classification is only part of the story. Each state has its own way of taxing LLCs, and it’s important not to overlook these nuances:

• State income tax conformity: Most states follow the federal classification for income tax. If you’re an LLC taxed as an S corp federally, your state will typically tax you as an S corp as well (meaning no corporate tax, pass-through to owners). But not always – a few states (and some cities like New York City) don’t recognize S corporations and treat them like regular corporations for local tax purposes. Always confirm how your state handles S corp or LLC income.
• Franchise taxes and fees: Many states impose annual taxes or fees on LLCs and corporations, often called “franchise tax” or an LLC fee. For example, California charges most LLCs an $800 annual tax plus a fee that scales with LLC income. Importantly, even if your California LLC elects to be taxed as an S corp, it still owes the $800 LLC tax (because legally it’s an LLC). On the flip side, California S corporations pay a 1.5% franchise tax on net income (minimum $800). In New York, an LLC must pay a filing fee each year (based on number of members and income) and S corps pay a fixed franchise tax or an income-based tax if large. Each state has its own system, so consider how an election might affect your state tax obligations.
• Separate state elections: Some states require you to file a separate form to be recognized as an S corp at the state level. New Jersey and New York State are examples – you have to file a state S corporation election in addition to the federal Form 2553. Failing to do so means your LLC might be treated as a C corp for state taxes even if it’s an S corp federally. Be sure to handle any necessary state paperwork when you change your LLC’s tax classification.
• Entity conversion vs. tax election: In some cases, it might make sense to legally convert your LLC to a corporation at the state level if you want to be treated fully as a corporation. For example, if your state’s laws impose fees on LLCs but not on corporations, an LLC taxed as an S corp might still pay those LLC-specific fees. By converting to a corporation and electing S corp, you could possibly avoid the LLC-specific fees. However, legal conversion has other implications and costs, so this is a decision to weigh carefully (typically with legal counsel).
• Local taxes: Check for city or county taxes that could be triggered by your entity type. Some cities have headcount taxes or gross receipts taxes that apply differently to LLCs vs corporations.
• Sales and use tax, and others: These generally aren’t affected by whether you’re LLC or S corp, as they’re based on transactions, but just keep in mind all the types of taxes your business may face beyond income (state unemployment tax, property tax on business assets, etc., are separate from income tax classification decisions).

In summary, do your homework for your state (and any state where you operate). The best federal tax strategy could come with different compliance steps or costs at the state level. Being blindsided by a state fee can eat into the savings you expected, so factor state and local obligations into your decision on how to have your LLC taxed.

Frequently Asked Questions (FAQs)

Can an LLC choose to be taxed as a corporation?
Yes. An LLC can file Form 8832 to be taxed as a C corporation, or file Form 2553 to be taxed as an S corporation, provided it meets the eligibility requirements.

Does a single-member LLC pay self-employment tax?
Yes. By default a single-member LLC’s profit is subject to self-employment tax because the owner is treated like a sole proprietor. Electing S corp status can reduce how much profit faces self-employment tax.

Is there a deadline to change my LLC’s tax classification?
Yes. To have an election apply for the current tax year, you generally must file by March 15 (if on a calendar year). Otherwise, the new tax status will start the next tax year.

Can I switch my LLC from S corp back to default taxation?
Yes. You can revoke an S corp election (or file Form 8832 to change classification back to disregarded/partnership). However, once changed, you normally must wait 5 years before electing S corp again.

Do I need an EIN to change my LLC’s tax status?
Yes. You should have an EIN for your LLC before filing an S corp or C corp election. Single-member LLCs using the owner’s SSN should get an EIN first.

Will changing my LLC’s tax status affect my legal liability protection?
No. Changing tax classification won’t affect your LLC’s liability protection. Your business remains an LLC and your personal liability shield stays intact, whether you’re taxed as a sole prop, S corp, or C corp.

Are LLC distributions taxed differently than salary?
Yes. Pass-through LLC distributions aren’t subject to Social Security/Medicare taxes, while salary is. However, distributions still face income tax, and C corp dividends are taxed at capital gains rates.

Can an LLC have different tax status at federal and state levels?
Yes. Some states tax LLCs differently. For example, your LLC could be an S corp federally but treated as a C corp in certain states. Always verify your state’s rules after changing your LLC’s tax status.

Should I consult a CPA to choose my LLC’s tax status?
Yes. Choosing a tax status has long-term implications. A CPA can analyze your situation and identify the most tax-efficient classification for your LLC, making sure you don’t miss any important considerations.