A limited liability company is a legal structure created under state law. It is not a federal tax classification by itself. For federal tax purposes, the Internal Revenue Service assigns a default classification based on the number of owners, unless the LLC elects to be taxed differently.
This distinction creates confusion. Many owners assume an LLC has its own fixed tax system. In reality, the same LLC can be taxed as:
- A disregarded entity
- A partnership
- An S corporation
- A C corporation
Understanding which category applies determines whether the LLC files Form 1065, Form 1120-S, or reports income directly on the owner’s return.
Default Federal Tax Classifications for LLCs
The IRS applies default rules unless an election is made.
A single member LLC is treated as a disregarded entity by default. The business does not file a separate federal income tax return. Instead, income and expenses are reported directly on the owner’s personal return.
A multi member LLC is treated as a partnership by default. The LLC must file Form 1065, U.S. Return of Partnership Income, and issue Schedule K-1 forms to each member.
An LLC can choose to be taxed as a corporation by filing Form 8832. It can then elect S corporation status by filing Form 2553 if it meets eligibility requirements.
These elections change how income is taxed and how forms are filed.
Disregarded Entity LLCs and Schedule C Reporting
A single member LLC that does not elect corporate taxation is considered a disregarded entity for federal income tax purposes.
The LLC does not file a separate income tax return. Instead, the owner reports business income and expenses on Schedule C of Form 1040 if operating as an individual.
If the owner is another entity, such as a corporation, income is reported on that entity’s return.
Key points about disregarded entities:
- The LLC still exists legally under state law
- The owner is subject to self employment tax on net earnings
- The LLC must obtain an Employer Identification Number if it has employees or certain tax obligations
- The LLC may still need to file payroll or excise tax returns
A common misconception is that disregarded entity status means the LLC is ignored entirely. It is ignored only for federal income tax purposes. It remains a separate legal entity for liability and state law purposes.
Multi Member LLCs and Form 1065 Filing Requirements
When an LLC has two or more members and does not elect corporate taxation, it is taxed as a partnership.
The LLC must file Form 1065 annually. This form reports the company’s income, deductions, credits, and other financial information. The partnership itself generally does not pay federal income tax.
Instead, the LLC issues Schedule K-1 forms to each member. These schedules show each member’s share of income, losses, deductions, and credits.
Members report the K-1 information on their personal or business tax returns and pay tax individually.
Important considerations for Form 1065 filers include:
- Filing deadline is generally March 15 for calendar year partnerships
- Failure to file can result in penalties assessed per partner per month
- Accurate allocation of income must follow the operating agreement
- Basis tracking is required to determine deductibility of losses
Partnership taxation requires careful bookkeeping and documentation. Errors can affect all members.
S Corporation Election and Form 1120-S
An LLC may elect to be taxed as an S corporation if it meets IRS eligibility rules. To qualify, the entity must:
- Have no more than 100 shareholders
- Have only eligible shareholders, generally individuals who are U.S. citizens or residents
- Have only one class of stock
The election is made by filing Form 2553 with the IRS. Once approved, the LLC files Form 1120-S annually.
Like partnerships, S corporations are generally pass through entities. The entity files an informational return and issues Schedule K-1 forms to shareholders.
However, there is a significant difference in how compensation is handled. Owners who work in the business must receive reasonable compensation as wages subject to payroll taxes. Additional profits can be distributed as dividends that are not subject to self employment tax.
This structure can reduce overall self employment tax in certain situations. However, it introduces payroll compliance obligations and stricter operational requirements.
Comparing Form 1065 and Form 1120-S
Both partnerships and S corporations are pass through entities, but their compliance obligations differ.
Partnerships under Form 1065:
- Do not require owners to receive wages
- Allocate profits according to the operating agreement
- Subject active members to self employment tax on business income
S corporations under Form 1120-S:
- Require reasonable salary for working owners
- Distribute remaining profits as dividends
- Potentially reduce self employment tax exposure
The choice between partnership and S corporation taxation should be based on income level, administrative capacity, and long term goals.
An S corporation election may not be beneficial for very small businesses with modest profits, as payroll costs can offset tax savings.
C Corporation Election and Form 1120
Although this article focuses on Form 1065 and Form 1120-S, it is important to note that an LLC can also elect to be taxed as a C corporation by filing Form 8832.
In that case, the entity files Form 1120 and pays corporate income tax directly. Shareholders pay tax again on dividends, creating potential double taxation.
C corporation status may be appropriate for businesses planning to retain significant earnings or seek certain types of investment.
Self Employment Tax Considerations
For disregarded entities and partnerships, active members generally pay self employment tax on their share of net earnings.
Self employment tax covers Social Security and Medicare contributions. It is in addition to federal income tax.
S corporation shareholders who receive wages pay payroll taxes on salary but not on dividend distributions. However, the IRS requires that wages be reasonable based on services performed.
Improperly minimizing wages to reduce payroll taxes can trigger IRS scrutiny and reclassification of distributions as wages.
Estimated Taxes and Withholding
LLCs taxed as disregarded entities or partnerships do not typically withhold federal income tax for owners. Members must make quarterly estimated tax payments if they expect to owe tax.
Failure to pay sufficient estimated taxes can result in penalties.
S corporation shareholders may receive wages subject to withholding. However, they may still need to make estimated payments if distributions generate additional tax liability.
Planning for cash flow and tax obligations throughout the year is essential.
State Tax Implications
Federal classification does not automatically determine state tax treatment. Some states impose additional franchise taxes, gross receipts taxes, or minimum fees on LLCs regardless of federal classification.
States may also require separate partnership or S corporation filings.
Always review state department of revenue guidance to ensure compliance beyond federal obligations.
Common Errors and Misunderstandings
Many owners believe that filing Form 1065 means the LLC pays tax. In reality, the partnership itself generally does not pay federal income tax.
Another misconception is that S corporation status automatically lowers taxes. While it can reduce self employment taxes in certain income ranges, payroll compliance and administrative costs must be considered.
Some single member LLC owners incorrectly assume they never need an Employer Identification Number. If the LLC has employees, excise taxes, or certain banking requirements, an EIN is mandatory.
Finally, failure to file required informational returns, even when no tax is owed, can result in significant penalties.
Practical Recommendations for LLC Owners
Maintain accurate accounting records throughout the year. Waiting until tax season increases risk of errors.
Track member capital accounts carefully in multi member LLCs. Basis calculations determine whether losses are deductible.
Consult a qualified tax professional before making S corporation elections. The decision should consider projected profits, compensation expectations, and compliance capacity.
Review filing deadlines annually and calendar them in advance.
Federal tax compliance is ongoing, not a once per year task.
Referenced Resources
Internal Revenue Service Limited Liability Company Information
https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc
Internal Revenue Service Form 1065 Instructions
https://www.irs.gov/forms-pubs/about-form-1065
Internal Revenue Service Form 1120-S Instructions
https://www.irs.gov/forms-pubs/about-form-1120-s
Internal Revenue Service Form 2553 Election by a Small Business Corporation
https://www.irs.gov/forms-pubs/about-form-2553
Internal Revenue Service Self Employment Tax Overview
https://www.irs.gov/businesses/small-businesses-self-employed/self-employed-individuals-tax-center