Taxation of Limited Liability Companies
What You Should Know About How an LLC is Taxed
In teaching continuing education classes around the country, I have found an interesting trend in the methods being used to form businesses. The limited liability company (LLC) has become widely used, possibly the most common form of business entity choice. There are several reasons for this including the simplicity of formation, the lower administrative burden when compared to corporations and partnerships, similar liability protection as incorporation and flexibility as to taxation. All have contributed to its popularity.
Flexibility of taxation, however, also leads to confusion. The IRS and Congress helped with this confusion by taking several years to clearly define how a LLC is taxed. There is no separate tax law for LLCs. In fact, for several years the IRS attempted to look at each individual LLC and compare it to a corporation. If it was most like a corporation, then it was taxed as a corporation. If not, it was taxed as a partnership or a disregarded entity. As you can imagine this was confusing and difficult to enforce.
Finally the IRS and Congress came up with a much simpler process. First, there are the default rules. These rules apply if no other election is made. If an LLC has one member (owner), then the LLC will be disregarded. So if an individual forms a business as an LLC and makes no election to be treated otherwise, he will be treated as if the business is his sole proprietorship. Similarly if a corporation is a single member, the business will simply be included with the corporation’s other business activity on its income tax return. No separate return will be filed. If the LLC is a multi-member (more than one owner), the default treatment is a partnership. The entity would file a Form 1065 partnership return and fall under the tax rules for partnerships.
In addition to the default rules, the law allows a “check the box election.” This rule allows any LLC to elect to be treated as a corporation. This simply requires that the LLC file a form 8832 and “check the box” to be treated as a corporation. Of course there are time requirements for filing and the entity must qualify for the tax treatment applied for. For instance, if the choice is to be a Sub-S corporation, the number of members and the class of ownership rules has to be met. Also, the election to be treated as a Sub-chapter S corporation must be timely filed.
The decision of how to treat your LLC should not be made lightly. If you elect to be treated as a corporation and then decide to change back, this could result in a taxable liquidation of the corporation. Also, once you elect to change the treatment of the LLC you will not be allowed to change again for five years. Finally, all the rules that apply to the reporting method you choose will apply to your entity. If you are being treated as a corporation, all the tax law applicable to corporation will apply to your LLC. You should consider all the options before making a decision.
Would you like additional information about taxation of Limited Liability Companies? Contact me at jlundy@osullivancreel.com or call 850-682-0791 if you have any questions or wish to discuss a particular issue in more detail.