A limited liability company (LLC) is a type of business association formed under state law that combines the best parts of being a disregarded entity and being a corporation. Generally, disregarded entities (e.g. sole proprietors and partnerships) enjoy pass-through taxation where profits are not taxed at the company level, but the owners may be personally liable for the business’s debts. On the other hand, corporations provide a shield to protect shareholders from being personally responsible for corporate liability, but profits are subject to double-taxation at both the corporate level and in the hands of the stockowners. The beauty of an LLC is that the owners get the benefit of the corporate shield from liability and the savings that comes from being a pass-through entity. It’s no wonder that this type of company formation is popular among large and small business operations alike.
Since the LLC is not exactly a disregarded entity and not exactly a corporation, how exactly is it taxed?
Under state law, an owner of an LLC is referred to as a member. An LLC with one owner is referred to as a single-member LLC. An LLC with several members is referred to as a multiple member LLC.
By default, a single member LLC is taxed as a disregarded entity separate from its owner (e.g. a sole proprietorship). Also by default, a multiple member LLC is taxed as a partnership. In either situation, the LLC is considered a “pass-through” entity for tax purposes where the business’s profits and losses will flow through to the personal tax return of each member. In this scenario, the business income is only taxed once.
However, LLCs can also elect be taxed as either an S-Corporation or a C-Corporation as defined under the Internal Revenue Code. A C-Corporation is the classic model of a corporation where the entity is distinct and separates its assets and income from that of its shareholders. The shareholder’s maximum exposure to personal liability from losses against the corporation is limited to the money they have invested in the corporation (unless a court allowed a judgment debtor to somehow “pierce the corporate veil”). The income of the corporation is taxed twice, once at the corporate level up to 21% and again in the hands of the shareholders on their individual returns.
If you elect to have your LLC taxed as an S-Corporation, then there are substantial benefits available. If eligible, it provide the liability protection for shareholders of a corporation while avoiding the double taxation. To be qualified as an S-Corporation under the Internal Revenue Code, all of the following is required:
- There are no more than 100 shareholders. 26 U.S.C. §1361(b)(1)(A).
- There are no shareholders who are not an individual or certain estates and trusts. 26 U.S.C. §1361(b)(1)(B).
- There are no shareholders that are non-resident aliens. 26 U.S.C. §1361(b)(1)(C).
- There is no more than one class of stock. 26 U.S.C. §1361(b)(1)(D).
- The small business corporation is NOT one of the following “ineligible corporations”:
- A financial institution which uses the reserve method of accounting for bad debts. 26 U.S.C. §1361(b)(2)(A).
- An insurance company. 26 U.S.C. §1361(b)(2)(B).
- A domestic international sales corporation. 26 U.S.C. §1361(b)(2)(C).
WHAT ARE THE TAX ELECTIONS AVAILABLE TO THE LLC AND HOW DO YOU MAKE THE CHOICE?
- SOLE PROPRIETORSHIP: A single-member LLC is considered a disregarded entity by default. The LLC may elect this classification by filing Form 8832 – Entity Classification Election to make the election or do nothing at all. The sole proprietor and his LLC may be legally distinct under state law, but they are considered one and the same under the Internal Revenue Code. As a disregarded entity, the LLC’s income, losses, deductions and credits pass through to the sole proprietor to report on Schedule C of their Form 1040 personal tax return.
- PARTNERSHIP: A multiple-member LLC is considered a partnership by default. The LLC may elect this classification by filing Form 8832 – Entity Classification Election to make the election or do nothing at all. The partnership is also a pass-through entity where all of the LLC’s income, losses, deductions and credits pass through to each partner’s individual tax returns. The LLC will have to file Form 1065 – U.S. Return of Partnership Income and provide a Schedule K-1 to each partner to show their amount of income, losses, deductions and credits that were reported to the IRS. Partnerships have great flexibility in allocating income, losses, deductions and credits as they agree in the Operating Agreement. It does not have to be necessarily based on the ownership interest in the LLC.
- S-CORPORATION: To become taxed like a S-Corporation, an LLC may elect to do so by a vote of all of its shareholders. 26 U.S.C. §1362(a)(1). An election to become an S-Corporation is only valid if ALL shareholders in the corporation on the day the election is held consent to it. 26 U.S.C. §1362(a)(2). The LLC must submit Form 2553 – Election by a Small Business Corporation signed by all the shareholders to the IRS to officially convert to S-Corporation status. The S-Corporation is also a pass-through entity where all of the LLC’s income, losses, deductions and credits pass through to each shareholders’s individual tax returns. The LLC will have to file Form 1120-S – US Income Tax Return for an S-Corporation and provide a Schedule K-1 to each partner to show their amount of income, losses, deductions and credits that were reported to the IRS. The amount of income, losses, deductions and credits is determined on a pro rata basis based on the shareholder’s stock ownership in the company (unlike the partnership where this can be determined by agreement).
- C-CORPORATION: To become taxed like a C-Corporation, the LLC must file Form 8832 – Entity Classification Election to make the election. The LLC will have to report its own income, losses, deductions and credits on Form 1120 – U.S. Corporation Income Tax Return. The owners of the corporation will report any wages, salaries, dividends or other distributions from the company based on information reported from W-2s and 1099s. Income is taxed twice at both the corporate level and the owner’s personal level, unlike a pass-through entity.
The manner in which your LLC should be taxed is a big decision and should be made in consultation with tax professionals or legal counsel. Our law firm provides both skilled lawyers and professional tax advisors to assist you in making this choice. If you have any further questions about taxation of LLCs or need legal representation, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.