Forming your business as a limited liability company (LLC) offers important protections from personal liability as well as operational flexibility. Choosing how your LLC is taxed can be just as important as choosing the entity form itself. Under federal tax rules, an LLC formed under the laws of any state (including Alabama) is initially assigned a default tax classification, but owners may elect to be taxed differently depending on the company’s income, ownership structure, and long-term plans. Understanding these options will help ensure that your LLC’s tax structure supports your business goals and overall financial strategy.
An LLC is considered “tax‐flexible” for federal income tax purposes, meaning it can be taxed in one of four ways: as a disregarded entity (or sole proprietorship), a partnership, a C-corporation, or an S-corporation. We will explore these different tax classifications below.
- Default Tax Status of an LLC
The Internal Revenue Service (IRS) assigns a default classification to an LLC as soon as it is formed, based on the number of members:
- A single-member LLC is treated as a “disregarded entity,” which means its income is reported directly on Schedule C (Form 1040) of the owner’s personal tax return, just like a sole proprietorship.
- A multi-member LLC is treated as a partnership for tax purposes. The LLC files a Partnership Return (Form 1065), and each member reports their share of the profits or losses on a Schedule K-1 attached to their personal tax return.
This default “pass-through” treatment applies automatically unless the LLC files a formal election with the IRS to be taxed as a corporation. Under the default classification, income passes directly to the members and the LLC itself does not pay federal income tax, which helps owners avoid the double taxation that corporations typically face.
- Does an EIN Application Elect Your Tax Classification?
A common point of confusion for business owners arises when the LLC applies for its federal Employer Identification Number (EIN). The IRS requires the applicant to indicate:
- The number of LLC members; and
- Whether the LLC expects to be taxed as a corporation.
However, your EIN application does not elect your tax classification. It only tells the IRS what your LLC’s default classification should be based on the number of members, or what classification you may intend to elect later.
Regardless of what is checked on your Form SS-4 EIN Application or in the IRS online EIN system:
- Electing C-corporation status requires filing Form 8832 with the IRS; and
- Electing S-corporation status requires filing Form 2553 with the IRS.
If no election form is filed, the IRS will treat your LLC under the default rules even if your EIN application suggests otherwise.
- When Being Taxed as a Disregarded Entity or Partnership Makes Sense
Electing to remain taxed under the IRS’s default pass-through classification (partnership for multi-member LLCs, disregarded entity for single member LLCs) is often appropriate when:
- You want profits or losses to flow directly to your personal tax return (and to your members’ personal returns, if applicable) without the LLC paying a separate entity-level tax;
- You have member-owners actively operating the business, and the resulting self-employment taxes are expected and acceptable; and
- You want maximum flexibility in how profits and losses are shared among members, as partnership tax rules allow allocations that match the terms of your operating agreement.
Choosing to stay with the default classification is often simpler and less burdensome for smaller, owner-managed LLCs, especially those that don’t expect to retain large profits or pursue complex capital arrangements.
- When to Elect Corporate Taxation
An LLC may elect to be treated as either a standard corporation (also referred to as a “C-Corporation”) or, if qualified, as an S-corporation by filing certain forms with the IRS (Form 8832 for C-corporations and Form 2553 for S-corporations). Remember that these elections are made with the IRS, not with the Alabama Secretary of State.
Electing C-Corporation Status
Filing Form 8832 permits your LLC to be taxed like a C-corporation. You should choose this election if your business wants to keep profits in the company, offer certain employee benefits, or attract investors. Remember that C-corporation status involves “double taxation,” meaning the company pays its own taxes first, and owners pay tax again on any dividends they receive.
Electing S-Corporation Status
Filing Form 2553 permits your LLC to be taxed as an S-corporation, which is a special type of corporation that retains pass-through taxation but is subject to additional IRS rules. An S-corporation does not pay federal income tax at the entity level; instead, profits “pass through” to the owners’ personal tax returns. However, under the S-corporation classification, owners who work in the business must take a reasonable salary, which is taxed as normal wages, and can receive the remaining profits as distributions, which are often taxed more favorably and may reduce self-employment taxes. To qualify for S-corporation status, your LLC must follow strict IRS rules regarding the number and type of owners and is allowed to issue only a single class of stock.
- Timing of a Tax Classification Election
You can choose to be taxed as a C-corporation or S-corporation shortly after forming your LLC or later, but the IRS sets strict deadlines for when the election takes effect:
- Form 8832 (C-corporation election): You can choose a date for the election to start that is up to 75 days before the IRS receives your form, or up to 12 months after filing. This means your C-corporation status can be applied retroactively to cover income and expenses from earlier in the year, if desired.
- Form 2553 (S-corporation election): The election is generally due within 2 months and 15 days after the start of the tax year for which it applies. If you miss this deadline, the IRS may still allow a late election if you can show reasonable cause.
Once your tax election takes effect, your LLC must follow the tax rules that apply to that classification. Note that switching your tax status later is not always simple. Once an LLC elects to change its tax classification by filing Form 8832 or Form 2553, it cannot make another election to change that classification for the sixty (60) months after the effective date of the initial change, unless certain exceptions apply or IRS consent is obtained.
- Alabama-Specific Considerations
Alabama follows federal rules for LLC tax classification and does not impose a separate state-level system. There are no unique exemptions, restrictions, or alternate election methods under Alabama law that change or override federal classification rules. However, your LLC will still need to file the required Alabama state income tax and related forms based on its federal classification.
- Key Considerations Before Electing
Before deciding how your LLC should be taxed, it’s important to evaluate several key factors:
- Consider whether your business generates mostly active income (from operations) or passive income, as this can affect the best tax treatment.
- Think about how profits will be paid to owners and, in the case of an S-corporation election, how salaries and distributions will be handled.
- Ensure your LLC’s operating agreement aligns with the tax election you choose, including rules for allocating profits/losses and handling membership changes.
- Consider whether you plan to reinvest profits, distribute earnings, raise outside capital, add multiple members, or eventually sell or exit the business. These plans can influence the most suitable tax classification.
- Many states, including Alabama, follow the LLC’s federal classification, so your choice can affect state income tax and reporting requirements.
- Corporate tax treatment usually involves more paperwork, formalities, and compliance obligations than default LLC taxation.
Conclusion
Determining how your LLC will be taxed is one of the most strategic decisions a business owner can make. For many LLCs, the default pass-through classification provides maximum simplicity and flexibility. For others, electing C-corporation or S-corporation taxation may be more advantageous. Regardless of the path you chose, the tax classification must be formally elected with the IRS, and Alabama will follow that election for most state tax purposes. A careful evaluation with a tax professional will ensure that your LLC’s classification matches your operational and financial goals.
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Important Reference Links:
Federal (IRS) Forms and Guidance
- Form 8832 — Entity Classification Election (C-Corporation Election)
https://www.irs.gov/forms-pubs/about-form-8832 - Form 2553 — Election by a Small Business Corporation (S-Corporation Election)
https://www.irs.gov/instructions/i2553 - Form SS-4 — Application for Employer Identification Number (EIN)
https://www.irs.gov/forms-pubs/about-form-ss-4 - IRS Guidance on LLC Classification
https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc