Publication 3402 Summarized — Taxation of Limited Liability Companies

It explains how the IRS classifies an LLC for federal tax purposes, and that question matters more than most owners expect. The starting point is simple. An LLC is a creature of state law. You file articles of organization with a state, you get liability protection, and you have an entity. But the federal tax code does not have a tax box labeled LLC. So the IRS slots your LLC into one of three existing buckets, and IRS Publication 3402 walks through how that slotting works. The publication is short, but the rules it summarizes drive almost every tax decision a small business owner faces in the first few years.

Here is the default rule, which is the heart of the whole document. If your LLC has one owner, the IRS treats it as a disregarded entity. That means it does not file its own income tax return. Its income and expenses flow onto the owner Schedule C, or onto a Schedule E if it holds rental property, or onto the owner corporate return if the owner is a corporation. If your LLC has two or more owners, the default treatment is a partnership, which files Form 1065 and issues a Schedule K-1 to each member. Those are the defaults. You land in them automatically unless you file a form to change course. No paperwork is required to accept the default. The default accepts you.

The third path is election. An LLC can ask to be taxed as a corporation by filing the entity classification election, and from there it can also ask to be taxed as an S corporation. We get into both of those below, but the publication frames them as opt-in choices layered on top of the defaults. Nothing happens automatically toward corporate treatment. You have to act, you have to file the right form, and you have to meet a deadline.

Why does the federal classification carry so much weight? Because it drives the form you file, the self-employment tax you pay, the way losses pass through, and even whether you can pay yourself a salary. A single-member LLC owner who never files an election owes self-employment tax of 15.3 percent on the net profit, and a lot of owners do not see that bill coming. A multi-member LLC owner gets a K-1 and may owe self-employment tax on the distributive share. The classification is the lever that moves all of it, and pulling the wrong way costs real money over a career.

One worked example. Say Maria runs a design studio as a single-member LLC and nets 120,000 dollars in 2026. By default she reports that on Schedule C, pays income tax at her bracket, and pays roughly 18,360 dollars in self-employment tax before the deduction for half of it. If she instead elected S corporation treatment and paid herself a reasonable salary of 70,000 dollars, payroll taxes would apply only to that 70,000, and the remaining 50,000 would pass through without self-employment tax. That swing is exactly why the classification deserves real attention, and why we run the numbers before anyone files anything.

Here is the mistake we see every year. Owners assume forming an LLC changed their taxes. It usually did not. The default disregarded or partnership treatment means your tax picture often looks the same as it did before you formed the entity. The federal tax identity is separate from the state law shell, and you have to choose to change it. An edge case worth flagging is the LLC owned by another entity rather than an individual, where the disregarded income flows up to the parent return instead of a personal 1040, which changes the planning entirely. If you want help mapping the right classification to your situation, our entity formation and structuring work is the place to start, and you can reach us through our new client inquiry page to talk it through with a person rather than a form.

The number of owners decides your default, full stop. A single-member LLC is disregarded as separate from its owner. A multi-member LLC is a partnership. Both defaults happen by operation of law the moment the entity exists, with no form filed and no election made. IRS guidance on the LLC lays this out plainly, and it is the rule we apply first for every new client who walks in with a freshly minted LLC. Get the default right and most of the rest of the planning falls into place.

Take the single-member case first. Disregarded means the IRS looks straight through the LLC to the owner. If you are an individual, your LLC profit lands on your Form 1040, usually on Schedule C for an active trade or business. You still use the LLC name on contracts, you still keep the liability shield under state law, but for federal income tax the entity is invisible. You pay income tax at your personal rates, and you pay self-employment tax of 15.3 percent on the net earnings up to the Social Security wage base of 184,500 dollars for 2026, with the Medicare portion continuing above that. One wrinkle owners miss. A single-member LLC is still treated as a separate entity for employment taxes and certain excise taxes, so if you have payroll, the LLC uses its own employer identification number for those filings even though it is disregarded for income tax.

Now the multi-member case. Two or more members default to partnership treatment. The LLC files Form 1065, an information return, and hands each member a Schedule K-1 showing that member share of income, deductions, and credits. The partnership itself pays no income tax. Each member reports the K-1 figures on a personal return and pays tax there. A general rule of thumb. Members who actively work in the business typically owe self-employment tax on their distributive share, while a true passive investor may not. That line is fact specific and worth a real conversation, because guaranteed payments and the level of participation both pull on the answer. The partnership return also carries its own deadline of March 15 for a calendar year filer, a month ahead of the personal return, and a late Form 1065 racks up a per-member penalty for every month it sits unfiled. That penalty surprises owners who thought the entity had no real filing because it pays no tax, so we calendar the partnership deadline separately from the personal one.

A worked example shows the split. Imagine three friends form an LLC to run a coffee roaster, sharing profits equally, and the business nets 150,000 dollars in 2026. No federal income tax is due at the entity level. Each member gets a K-1 for 50,000 dollars, reports it on a personal return, and pays income tax plus, for the active members, self-employment tax on that amount. If one of the three only put in money and never works in the shop, her share may escape self-employment tax, which is a meaningful difference at scale. Over five years that distinction can add up to a five-figure number for a single member.

The error we correct most often involves married couples. Two spouses who co-own an LLC in a common law state default to a partnership and owe a Form 1065, which surprises people who thought they had a simple joint venture. In community property states the IRS allows a husband and wife LLC to be treated as a disregarded entity instead, which avoids the partnership return. New York is a common law state, so a two-spouse LLC here generally files the partnership return unless one spouse is dropped from ownership. Getting that right at formation saves a return and a headache. An edge case to watch is a single-member LLC that adds a second member mid-year, which converts the entity from disregarded to partnership on the date of the change and triggers a short-year filing. Our team handles this through entity formation and structuring work and through ongoing tax strategy consulting, and when a partnership return is genuinely required we prepare it correctly the first time. Reach out through our new client inquiry page if your ownership is about to change.

You file the check-the-box election when you want your LLC taxed as a corporation instead of a disregarded entity or a partnership. The form that does it is Form 8832, the entity classification election, and the IRS page about Form 8832 explains the mechanics. This is the single most powerful classification tool in the whole publication 3402 taxation of limited liability companies framework, because it lets you override the default and pick C corporation treatment with one filing. The election is what the phrase check-the-box refers to, since you literally check a box on the form to choose your federal tax status.

Here is what the form actually does. By default, as we covered, a single-member LLC is disregarded and a multi-member LLC is a partnership. Form 8832 lets an eligible entity elect to be taxed as a corporation. Once that election is in place, the LLC files Form 1120 as a C corporation, pays the flat 21 percent federal corporate income tax on its profit, and the owners pay tax again on dividends they take out. That second layer of tax is the famous double taxation, and it is the reason most small LLCs do not rush into a straight C election. But for a business reinvesting profit, seeking outside investors, or planning around fringe benefits, the C path can make sense. Venture-backed companies in particular almost always want corporate treatment so they can issue preferred stock and qualify for the qualified small business stock rules.

Timing matters and the rule is specific. The election can take effect up to 75 days before you file the form or up to 12 months after. So you have a window. If you want corporate treatment starting January 1, you generally file the form within 75 days of that date, though late election relief exists if you miss it for reasonable cause. Once you make the election, a 60 month limitation applies. You generally cannot change your classification again for five years, which stops owners from flipping treatment year to year to game the rules. Choose deliberately, because you are committing. The clock starts on the effective date of the election, not the date you file, so plan the date with care. There is also a practical filing point worth knowing. Form 8832 has to be signed by everyone who is an owner on the effective date, or by an officer authorized to make the election, and a missing signature is the most common reason the IRS bounces the form back. We chase down those signatures before the package goes out so the election is not delayed by a paperwork slip.

A worked example clarifies the stakes. Suppose a software LLC nets 400,000 dollars in 2026 and the owner wants to keep most of it inside the company to fund growth. As a disregarded entity she pays personal income tax and self-employment tax on the whole 400,000 whether she takes the cash or not. If she files Form 8832 to be taxed as a C corporation, the company pays 21 percent, or 84,000 dollars, on its income, and she only pays a second layer of tax on the dividends she actually distributes. If she leaves money in the business, that second layer waits. For a high reinvestment business the deferral can be worth real money, though the personal holding company rules and accumulated earnings tax can bite if cash just piles up with no plan.

The mistake we see every year is owners filing Form 8832 when they actually wanted S corporation treatment. Those are different elections. If your goal is to pay yourself a salary and pass the rest through without double tax, you usually want the S route, not a bare C election. An edge case worth knowing is that a properly filed Form 2553 can carry the corporate classification election with it, so an LLC heading straight for S status often does not need a separate Form 8832 at all. We sort out which form fits before anything gets mailed, and we handle the resulting corporate return preparation once the election is live. If you are weighing this choice, start a conversation through our new client inquiry page and we will walk the trade-offs with you.

An LLC elects S corporation status by filing Form 2553, and the payoff is a reduction in self-employment tax when it is done right. The IRS page about Form 2553 covers the election, and it is the move that drives most of the tax planning we do for profitable single-member and small multi-member LLCs. The logic is clean. An S corporation owner who works in the business pays a reasonable salary, runs payroll taxes on that salary, and takes the remaining profit as a distribution that escapes the 15.3 percent self-employment tax. That gap between salary and distribution is where the savings live.

The mechanics first. An LLC that wants S treatment files Form 2553, and in many cases that single form is enough because the IRS treats a timely Form 2553 as also making the underlying corporate classification election. The deadline is firm. You generally file within two months and 15 days of the start of the tax year for which the election is to take effect, so for a calendar year that lands around March 15. Late election relief is available for reasonable cause under Revenue Procedure 2013-30, and we use it often for owners who learn about the strategy mid year. Once the S election is active, the LLC files Form 1120-S and issues a K-1 to each owner. The S corporation also has to meet eligibility rules, including a cap of 100 shareholders and a ban on most nonresident alien owners, which rules the election out for some ownership structures.

Now the self-employment tax angle, which is the whole reason owners do this. As a disregarded entity, every dollar of net profit is subject to self-employment tax up to the wage base. As an S corporation, only the salary portion is subject to Social Security and Medicare tax. The distribution is not. The catch is the reasonable compensation rule. The IRS requires the owner to pay a salary that reflects the real value of the work, and lowballing the salary to dodge payroll tax is a classic audit trigger. You cannot pay yourself 10,000 dollars and call 200,000 dollars a distribution. Courts have repeatedly sided with the IRS when owners pushed the salary too low, and the recharacterized wages come with back payroll tax plus penalties and interest.

A worked example shows the savings. An owner nets 150,000 dollars in 2026. As a disregarded entity she pays self-employment tax of roughly 21,000 dollars before the income tax deduction for half of it. Elect S status, pay a defensible salary of 85,000 dollars, and payroll taxes apply to that 85,000, costing about 13,000 dollars in combined Social Security and Medicare. The remaining 65,000 distribution carries no self-employment tax. The gross saving is in the range of 8,000 dollars, before factoring the cost of running payroll and a separate return. That is why we run the math before recommending it, since the savings have to clear the added compliance cost to be worth the trouble.

The error we see every year is an owner who made the election but never set up payroll, taking everything as a distribution with no salary at all. That is the fastest way to lose the strategy in an exam, because the IRS can recharacterize distributions as wages and add back payroll tax plus penalties. The other miss is electing S status on a business that does not earn enough to clear the added cost of payroll and an 1120-S. Below roughly 40,000 to 50,000 of net profit, the savings often do not justify the overhead. An edge case worth a flag is that S corporation owners lose some fringe benefit advantages, since health insurance for a more than two percent owner has to run through W-2 wages. We size this for each client through tax strategy consulting and prepare the resulting corporate return preparation so the salary and distribution split holds up. Reach us through our new client inquiry page to see if the numbers work for you.

Because the two systems were built separately, and that gap is the single idea every LLC owner needs to hold in their head. State law creates the LLC and gives you liability protection. Federal tax law decides how that LLC is taxed, and it does so using categories that predate the LLC entirely. The whole point of the publication is to bridge that gap, and IRS Publication 3402 is the document the IRS wrote to do it. Once you see the two layers clearly, the rest of the rules stop feeling arbitrary.

Think of it as two layers. On the state layer, your LLC is real. It owns assets, signs contracts, shields your personal house and savings from business creditors, and exists until you dissolve it. On the federal layer, the IRS asks a different question. How many owners do you have, and have you filed any election? The answer puts you in a tax box that has nothing to do with the LLC label on your formation documents. A single-member LLC is a disregarded entity for income tax. A multi-member LLC is a partnership. Either one can elect corporate or S corporation treatment. The state shell stays the same while the federal identity shifts underneath it.

This separation creates real consequences owners should plan around. Your liability protection does not depend on your tax classification, so electing S corporation status does not weaken your legal shield, and staying a disregarded entity does not strengthen it. The two move independently. IRS guidance on the LLC makes the same point. The LLC is a state entity, and federal classification is a separate determination layered on top. You can change your federal tax treatment without touching your state registration, and you can change your state structure without automatically changing your federal taxes. That independence is a feature, because it lets you tune the tax side as the business grows without disturbing the legal side. It also means a single business can wear different hats in different systems at the same time, which is normal and not a red flag. The bank may know you as an LLC, the state knows you as an LLC, and the IRS may know you as an S corporation, all describing the same company. We make sure the EIN paperwork, the bank records, and the tax returns all point to the same entity so nothing falls out of sync during an exam.

A worked example ties it together. Imagine an owner forms a single-member LLC in New York, defaults to disregarded status, and reports on Schedule C while netting 200,000 dollars in 2026. Two years later she files Form 2553 to be taxed as an S corporation. Her New York LLC registration never changes. Her operating agreement never changes. Her liability shield never changes. What changes is the federal return she files and the self-employment tax she pays. Same legal entity, new tax identity. That is the separation working exactly as designed, and it is why we revisit classification every couple of years for clients whose profit keeps climbing.

The mistake we see every year is owners who think one decision settles everything. They form the LLC, assume the tax question is handled, and never revisit it as profit grows. The right approach is to treat the state formation and the federal classification as two separate choices, both worth reviewing as the business changes. New York adds its own layer too, including a filing fee tied to gross income and city level rules that can surprise people, so the state and federal pictures rarely line up cleanly. An edge case to keep in mind is moving an LLC to a new state, which can require a new registration or a conversion while leaving the federal classification untouched. We map the state entity and the federal tax identity together through our entity formation and structuring work and keep them aligned over time with tax strategy consulting. If your LLC has grown and you have never checked whether your classification still fits, come talk to us through our new client inquiry page and we will run the numbers.