LLC vs. Corporation: Differences in Tax Classification

By Kye Stüger (Accountant at ROMA Wealth Planning)

When a foreign entrepreneur starts looking into US companies, the first question that comes up is almost always the same: should I open an LLC or a corporation? There is a lot of content online about this, and most of it is presented with a high degree of certainty. But the way the question is usually asked is incomplete.

Forming a company in the United States answers only one part of the problem: what type of entity exists under state law. The Internal Revenue Service then asks a second, separate question: how will this entity be taxed for US federal income tax purposes? The answer to the first question does not automatically determine the answer to the second one. Many of the problems that show up in the first year of business come from not understanding this difference.

Legal structures: LLC and Corporation

Limited Liability Company (LLC)

An LLC (Limited Liability Company) is created under state law by filing a document usually called Articles of Organization (or a Certificate of Formation in some states) with the relevant state authority and paying the required fee. The document normally includes the company name and the name and address of the registered agent. The exact requirements and fees depend on the state.

From a legal point of view, an LLC is a separate entity. It can sign contracts, own property, open bank accounts and be sued in its own name. The main advantage is limited liability: if the business fails, the members normally lose only what they invested. Their personal assets are not generally used to pay the company’s debts, as long as the LLC is properly maintained and not abused.

An LLC can have one member or many members. How the company is managed, how profits are shared, and what happens when a member leaves or dies is usually defined in a private document called the operating agreement. This gives a lot of flexibility compared to a corporation.

Corporation

A corporation is also a separate legal entity created under state law and also provides limited liability to its owners. The structure is more formal. A corporation has shares, the owners are shareholders, and the company is managed by a board of directors that appoints officers (such as a CEO or CFO) to run the day-to-day business.

This more rigid structure is useful when the company plans to raise capital from investors or be sold.

So, at the state law level, there are basically two main types: LLCs and corporations. Both provide limited liability. The LLC is more flexible; the corporation is more standardized and investor-friendly.

Federal tax classification: disregarded, partnership, corporation

For US federal income tax purposes, the IRS does not really care whether the entity is called an LLC or a corporation under state law. What matters is how the entity is classified for tax purposes. There are three main classifications:

• Disregarded entity – the IRS ignores the entity for income tax purposes and treats the activity as if it were carried out directly by the owner.
• Partnership – the IRS treats the entity as a partnership: the entity itself does not pay income tax, but the profit is allocated to the partners, who are taxed on their share.
• Corporation – the IRS treats the entity as a separate taxpayer. The entity pays tax on its profit, and distributions to owners (dividends) may be taxed again at the owner level.

A “disregarded entity” is not a separate type of company. It is just a tax classification that the IRS applies to certain entities, typically a single-member LLC that has not elected to be taxed as a corporation. The LLC still exists as a legal entity, still has limited liability, and still owns its assets. The word “disregarded” only describes how the IRS treats it for federal income tax purposes.

Default classifications and elections

The classification often happens automatically, without any special form:

• A domestic LLC with one owner is by default a disregarded entity.
• A domestic LLC with two or more owners is by default a partnership.
• A corporation (under state law) is always treated as a corporation for federal tax purposes. It cannot be classified as a partnership or as a disregarded entity.

If an LLC wants a different classification, it can file Form 8832, Entity Classification Election. For example, a single-member LLC can elect to be taxed as a corporation, or a multi-member LLC can elect to be taxed as a corporation instead of a partnership. The election can be effective up to 75 days before the filing date or up to 12 months after, and once an entity changes its classification, it generally cannot change again for 60 months (five years).

Single-member LLC: disregarded entity and Form 5472

A single-member LLC that is treated as a disregarded entity does not file a separate US income tax return. For income tax purposes, the IRS treats the owner as if they were carrying out the business directly.

If the business is effectively connected with a US trade or business, the foreign owner will usually have to file a US tax return. For an individual, this is typically Form 1040-NR (US Nonresident Alien Income Tax Return), and tax is paid at individual rates on the effectively connected income.

Even though the LLC is disregarded for income tax, it still has compliance obligations. A US disregarded entity that is wholly owned by a foreign person must file Form 5472 every year. This form is attached to a pro forma (essentially blank) Form 1120. Form 5472 reports transactions between the LLC and its foreign owner, including capital contributions and distributions. Even putting money into your own company or taking money out can be a reportable transaction.

In practice, a foreign-owned single-member LLC will normally need to get an EIN (Employer Identification Number), even though it does not file an income tax return, because the EIN is needed for Form 5472 and for other administrative purposes (like opening a bank account).

Form 5472 must be filed according to the current IRS instructions, which specify how to submit the form and where to send it. The form requires identifying information for the foreign owner and, where applicable, tax identification numbers, as explained in the instructions. The penalty for not filing Form 5472 is $25,000, and there can be additional penalties of $25,000 for each 30-day period after the IRS sends a notice and 90 days have passed. An incomplete form can be treated as if no form was filed at all.

Multi-member LLC: partnership, Form 1065 and withholding

An LLC with two or more members that is treated as a partnership for tax purposes must file Form 1065 (US Return of Partnership Income). The partnership itself does not pay federal income tax. Instead, it issues a Schedule K-1 to each partner, showing their share of income, deductions, credits, etc. Each partner then reports this on their own tax return and pays tax on their share.

When there are foreign partners, the partnership also has to provide Schedules K-2 and K-3, which give more detailed information about international items (like foreign-source income, taxes paid abroad, etc.).

The main problem for foreign partners is not only the tax, but the cash flow. If the partnership is engaged in a US trade or business and has effectively connected taxable income (ECTI) allocable to a foreign partner, the partnership must withhold tax under Section 1446 and pay it to the IRS on behalf of the foreign partner. The withholding is calculated based on the ECTI and the applicable tax rates (up to 37% for individuals and 21% for corporations, depending on the situation). This withholding is required even if no cash is actually distributed to the partner. The foreign partner can later claim this as a credit on their US tax return, but in the meantime, part of the money is already gone.

There is also a rule that if a foreign partner sells their partnership interest, the buyer generally has to withhold 10% of the amount realized, under section 1446(f), unless an exception applies.

Corporation: Form 1120, 21% tax and dividends

If an LLC elects to be taxed as a corporation, or if the entity is a corporation from the beginning, it will normally be treated as a C corporation for tax purposes. A C corporation files Form 1120 and pays federal income tax on its taxable income. The basic corporate tax rate is a flat 21% for most C corporations.

One advantage of this structure for foreign owners is that the corporation’s operations do not, by themselves, create a personal US filing obligation for the shareholder. The foreign owner does not have to file a US individual tax return just because they own shares in a US corporation that does business in the US. For many foreign investors, this is a big advantage.

The disadvantage is double taxation. The corporation pays 21% tax on its profit. Then, when the corporation distributes dividends to the foreign shareholder, the US generally imposes a 30% withholding tax on the dividends. This rate can be reduced (sometimes significantly) if there is a tax treaty between the US and the shareholder’s country, and in some cases dividends may even be exempt. But if there is no treaty, the 30% rate applies.

Also, if a US corporation is at least 25% foreign-owned, it must file Form 5472, just like a foreign-owned disregarded entity, with the same $25,000 penalty for failure to file.

Changing tax classification

For the IRS, a change from one classification to another (for example, from a disregarded entity to a corporation, or from a partnership to a corporation) is often treated as if the old entity was liquidated and a new one was created. This can trigger tax consequences, even if no assets were sold and no money changed hands. That is why it is important to think carefully before changing
the classification and to check what tax cost the change itself might create.

Some changes happen automatically. For example:

• If a partnership ends up with only one owner, it becomes a disregarded entity.
• If a single-member LLC admits a second member, it becomes a partnership.

So bringing in a new investor or buying out a partner can unintentionally move the business into a different tax regime, even if no form is filed and nobody intended to change the classification.

Conclusion

There is no single “best” structure for everyone. Each option has advantages and disadvantages, especially for foreign owners.

A disregarded LLC is simple and cheap, but it puts the owner directly into the US tax system and has a serious reporting obligation (Form 5472) with a high penalty.

An LLC taxed as a partnership avoids corporate-level tax, but there can be significant withholding on effectively connected income, and the foreign partner still has to deal with US tax returns.

A corporation keeps the foreign owner out of the US filing system for the company’s operating income, but there is 21% corporate tax and potentially 30% withholding on dividends, unless a treaty helps.

In practice, the decision depends on a few key facts: whether the business is really operating in the United States, whether the owner’s country has a tax treaty with the US, and whether the profit will be distributed or kept in the company. Choosing a structure without thinking about these points can lead to costly consequences.