By Bert Seither, Director of Operations at Corporate Tax Network
About the author: Bert Seither is the Director of Operations at Corporate Tax Network, a national accounting and business development firm. For nearly 10 years, Seither has assisted small business owners to help put their companies on a path to prosperity.
In the small business landscape, a limited liability company (LLC) offers a good amount of flexibility to its owner(s). One of the many choices LLC owners have is to choose how they’d like their companies to be treated by the IRS in terms of taxes. This is formally called the entity classification election. Because of the numerous tax rules that the IRS places on small businesses, it is very important to consider the different options available and how the resulting tax structure of a business can affect the tax responsibilities of those behind it.
LLCs are classified under a few unique categories in terms of how they are structured tax-wise. These include S corporation status, C corporation status, sole proprietorship status, and partnership status. Choosing which of these structures to use is based on several different factors, including how many owners are involved in an LLC. The ultimate decision that leads to how an LLC is viewed by the IRS for tax purposes is known as the entity classification election. Sometimes abbreviated as ECE, this election is made when a business files its taxes using Form 8832: Entity Classification Election. For an S corporation, Form 2553 may be required to file as well, or it may be filed separately.
When it comes to the S corporation structure of an LLC, these business entities are not taxed at the corporate level. The shareholders invested in them instead split the taxes on their personal tax returns. An LLC arranged as a C corporation is taxed at the corporate level as a separate business entity. Taxes on LLCs structured as sole proprietorships and partnerships are passed through to their owners.
There are several reasons why you should understand how this election works if you own or plan to own an LLC. In basic terms, the ECE is designed to communicate to the IRS how an LLC owner wishes to have his or her company taxed. This election obviously has a major impact on the tax status of the business, which in turn determines how much money the business and its owners owe in federal income taxes. Because of the advantages and disadvantages to each election option, it’s vital to look at the details of each business entity on a case-by-case basis prior to making this integral decision.
If an LLC owner does not indicate to the IRS how he or she wants such a business to be treated from a tax standpoint, it could be taxed in a way that is much less desirable and may result in a substantially higher tax rate. This is because the IRS will automatically assume that an LLC owned by one individual should be treated as a sole proprietorship, and LLCs with multiple owners are considered partnerships. Sole proprietors generally have to file their business-related taxes on a personal tax return. The same goes for partnership owners who split up their earnings and report this income on their personal returns. If the IRS defaults an LLC to one of these structures, it could lead to higher taxes and fewer deduction opportunities. This alone demonstrates why it’s so important to make the appropriate election for an LLC.
After the ECE forms are filed with the IRS, LLC owners typically get an answer back on their election requests from the IRS via mail. In general, this election can’t officially take effect more than 75 days before the date that the election is formally filed with the IRS. On the other hand, it cannot take effect more than one year after the election filing date. Overall, the entity classification election is essential to putting an LLC on the right track for appropriate taxation purposes and for future financial success.