How are LLCs taxed?
This is mostly a trick question. From the Internal Revenue Service (IRS) point of view, a Limited Liability Company (LLC) is not taxed or recognized as a business formation. Although LLCs provide the limited liability of a corporation with easier reporting, they are treated the same as a Sole Proprietorship (a “disregarded” entity) or as a Partnership (a “pass-through” entity). Both Sole Proprietor and Partnership income and expenses are passed through to your individual income tax return (Form 1040).
LLCs are a state licensed entity that the majority of states do not tax. You file with the appropriate state agency, pay a fee and you have an LLC. Each state varies regarding which department to file with, how much to pay, whether or not there are state taxes associated with your LLC, and even how much limited liability the LLC is afforded. Privacy is an important issue for some, and the states also vary in how much they protect the business privacy of the LLC owner or owners. You can form an LLC in whichever state you think is most advantageous with regards to privacy, protection and taxability. The take-away here is to shop around.
An LLC owner is called a “member.” From a tax perspective, a single-member LLC usually defaults to being treated as a Sole Proprietorship while a multiple-member LLC defaults to being treated as a Partnership (LLP). The member or members can make additional elections to be treated as either an S-Corporation or a C-Corporation. Like an LLC, an S-Corporation is usually treated as a pass-through entity. A C-Corporation is a more complex and formal business type that pays its own corporation taxes and thus there is no “pass-through” activity associated with it.
Understanding the default rules for treating an LLC as either a Sole Proprietorship or a Partnership, and other available elections (such as choosing for your LLC to file as an S-Corporation or even a C-Corporation (not covered in this article). will help you choose the best business form for your situation. Make your decision strategically. Consider the short and long-term factors. Who are or will be the owners? Who and how will investors participate in your business (loans or equity)? How important is it at this time to limit liability for your business? If the LLC has more than one member, then perhaps a Partnership is the best business structure. If you wish to attract investors to your business venture, then perhaps an S-Corporation or even a C-Corporation would offer more incentives for investors.
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