Limited Liability Companies are becoming increasingly popular. Every state and the District of Columbia have some type of statutes governing the formation and operation of LLCs. They are normally used for businesses with small numbers of active participants, family/closely held businesses, real estate investments, joint ventures, and investment partnerships. Essentially, any business that is not contemplating an S-Corporation or C-Corporation should consider using an LLC.
An LLC has the characteristics both a partnership and a corporation. Like a corporation, members (the owners) are usually not personally responsible for the debts of the LLC. Like a partnership or sole proprietorship, it has greater flexibility and doesn't have to do formalities such as shareholder meetings.
The main advantage of an LLC is that its members are not personally liable for the debts of the business. Members have the same protections as shareholders of corporations or limited partners. But unlike limited partnerships, which require that at least one general partner be personally responsible for the debts of the business, no such requirement exists in an LLC.
The second big advantage is that the LLC can choose its federal tax treatment. An LLC can choose to be taxed as a partnership, a corporation, or as a sole proprietorship. Statistically, an LLC with more than one member usually elects to be taxed as a partnership and single-member LLCs elect to be taxed as sole proprietorships.
However, an LLC with more than one member (owner) can elect to be taxed one of three ways:
- Partnership
- C Corporation
- S Corporation
An LLC with only one member may choose:
- Disregarded entity (Sole Proprietorship)
- Corporation (e.g. C Corporation, personal holding company, personal services corporation or professional corporation)
- S Corporation
If no status is elected when filing for a LLC, the IRS will assign default classifications:
- Any business that is not a corporation is classified as a partnership; and
- Any entity that is owned by one single person will be taxed as a sole proprietorship
The reason for these elections is because LLCs are not specifically mentioned in the federal tax code and thus there are no regulations governing their taxation like there are for corporations and partnerships. Instead, LLCs may decide to taxed under one of the above classifications by filing Form 8832. If the taxpayer doesn't mind using the IRS default entity classification, then no Form 8832 needs to be filed.
Additional Consideration for Using LLCs
Many people are choosing LLCs because of other issues. For instance, LLCs are not subject to restrictions on the number and types of shareholders or the one-class-of-stock limitations that are imposed on S Corporations.
Another characteristic is the flexibility to allocate income/loss on a basis OTHER THAN each member's percentage interest in the LLC (partnership rules). In an S Corporation, allocations are based strictly on the basis of how much stock is owned.
Multiple member LLCs generally elect to be taxed as partnerships, which means that Form 1065 is sent to the IRS and each member receives a Schedule K-1 (1065) for their share. Each member then reports the partnership income on their personal return and pays any taxes based on their own tax rate.
The IRS does not have conclusive rules stating whether LLC members are subject to self-employment tax (social security and medicare), but based it on whether a member is a general or limited member. LLC members may be subject to self-employment tax if their responsibilities are like a general partner's. LLC members are not subject to self-employment if their interests are viewed as comparable to limited partnership interests, unless it is a guaranteed payment. (A guaranteed payment is an amount paid to a member for services rendered to or on behalf of the partnership, paid without regard to the income of the partnership.) We will go into this in more depth in the Partnership chapter.
Net profit from LLCs taxed as sole proprietorships are generally subject to self-employment taxes, as discussed in the previous chapter.