Limited Liability Companies, or LLCs, are a business structure allowed by state statute. Each state may use different regulations, but they are usually more or less similar in structure. One thing that you may not know, however, is that the “LLC” designation has little to do with how the company files their federal taxes.
When establishing a company, after registering as an LLC, you have several options on how you would prefer to be taxed. Note that not all options are available for all companies.
Single Member LLC
This includes both LLCs with one owner and LLCs with two owners who are married and living in a community property state. Unless the owner(s) file Form 8832 (C Corporation election) or Form 2553 (S Corporation election) to be classified as a corporation, they will be treated as a “disregarded entity” and file their taxes on Schedule C of their personal 1040. From a tax perspective, they are treated similarly to a sole-proprietor.
These are LLCs with two or more members. Unless they file Form 8832 or Form 2553, the IRS will classify them as a partnership, and they will file their business taxes on Form 1065. For LLCs of two or more unmarried partners, this is the default election and requires no taxation election. A partnership is what’s known as a “pass through” entity: the partnership files a tax return, but any profits or losses flow through to the owner’s personal return. The partnership will issue K-1s with this information to the partners, who will then use the information to complete their personal 1040.
If the owner/owners prefer, they can file Form 2553 and elect to be taxed as an S Corporation. One feature of an S Corporation is that the owner can pay themselves a salary, becoming a W-2 employee of the company. This feature is not available to either single-member LLC’s or partnerships; in those entities, the owners may only compensate themselves by taking draws from their equity. Like Partnerships, S Corps are “pass through” entities – the business files Form 1120S, and their profits and losses are passed to the owners through a K-1. If any of the partners or shareholders in the company are corporations themselves, or foreign entities, then the business cannot elect S Corp status.
This election is made by filing Form 8832. Some of the advantages of electing to be taxed as a C Corporation are that you’re allowed to have foreign investors, can have more than 100 shareholders, and can issue more than one type or class of stock. Also, some industries are not allowed to elect S Corp status (insurance companies, for example). The drawback is that, unlike the previous options, C Corporations are not pass-through entities. C Corps file Form 1120, and profits are taxed directly at the corporate level; if any of those profits are paid out to owners/shareholders, they will pay taxes on those same profits again – amounting to double-taxation of profits. Unfortunately, if the C Corporation takes a loss, the owners/shareholders aren’t able to write that loss off on their personal returns.
As you can see, there are quite a few options for LLCs out there. Determining which option is best for you depends on your particular situation; by using the above information as a starting point, you should have a good idea on which area you should pursue.