Oddly enough, as far as Federal income taxes are concerned, LLCs don’t really exist. The Internal Revenue Code (the body of law that outlines all Federal income taxation) treats each LLC as if it were one of the other types of entities (sole proprietorship or partnership usually).
Disregarded Entities
LLCs are referred to as “disregarded entities.” They are referred to in such a manner because Federal tax law tends to disregard their existence.
EXAMPLE: Kali owns and operates a restaurant as a sole proprietorship. She later decides to form an LLC for her business. Because the LLC is a disregarded entity, the business will continue to be taxed as a sole proprietorship (for Federal tax purposes at least).
EXAMPLE: Steve and Beth own and operate a winery. After learning about the potential dangers of unlimited liability in a partnership, they decide to form an LLC. Because the LLC is a disregarded entity, the business will continue to be treated as a partnership for Federal income tax purposes.
In other words, single-member LLCs (LLCs with one owner) will generally be taxed as sole proprietorships, and multiple-member LLCs will generally be taxed as partnerships. Because of this tax treatment, LLCs—like sole proprietorships and partnerships—are often referred to as pass-through entities.
LLCs Taxed as Corporations
Sometimes, after forming an LLC, the owner(s) of the LLC will decide that they would benefit from being taxed as a C-corporation rather than as a sole proprietorship or partnership. When this happens, the owner(s) have two options:
- Form a corporation and transfer all of the assets from the LLC to the corporation, or
- Fill out a form (Form 8832) electing corporate tax treatment.
The second option is certainly the easier and less costly of the two.
The same thing can be done should the LLC’s owner(s) decide that S-corporation taxation would be beneficial. The only difference is that a different form (Form 2553) is used to notify the IRS of the election.
Is Electing Corporate Tax Treatment for Your LLC Really a Good Idea?
Filling out a form to elect corporate tax treatment is certainly an easier method than actually forming a corporation, transferring all the assets from your LLC to the corporation, and then dissolving your LLC. However, many tax professionals recommend rather strongly against electing corporate tax treatment for a Limited Liability Company.
The reason many tax advisors are hesitant to elect corporate taxation for an LLC is not that corporate taxation is a bad thing. Rather, they’re concerned about the potential for problems resulting from two conflicting sets of laws. In other words, they’re uncomfortable with the situation resulting from a business being treated as an LLC for legal purposes, but as a corporation for tax purposes.
State Taxation of LLCs
Again—unless an election is made otherwise—LLCs will be treated as either sole proprietorships or partnerships for Federal tax purposes. However, depending upon where your business is located, state income taxes might not work the same way.
In some states, LLCs are taxed, by default, in a manner roughly the equivalent to the way that corporations are taxed. This makes for a rather complicated situation in which your business is treated by the IRS as a sole proprietorship (or a partnership if it has multiple owners), but as a corporation by your state.
Other states have a minimum annual income tax for LLCs (though it may be called something else). For instance, in California LLCs are subject to a “franchise tax,” which is basically just an income tax, but with an annual minimum of $800.
EXAMPLE: Braden runs a sole proprietorship in California for his part-time video production business. He earns roughly $3,000 per year from the business, and is considering forming an LLC. However, even with an annual income of only $3,000, a California LLC would still be subject to a tax of $800, or over one-quarter of its total profit. Braden eventually decides that the benefits of forming an LLC would be outweighed by this disproportionately large tax.
Before deciding to form an LLC, it’s definitely a good idea to find out precisely how your state taxes limited liability companies. Generally, you’ll be able to find this information online without too much difficulty by searching for your state’s Treasury Department, Department of Revenue, or corresponding organization.
In Summary
- For Federal tax purposes, single-owner LLCs are treated as sole proprietorships, and multiple-owner LLCs are treated as partnerships.
- The owners of an LLC can elect to be treated as a corporation simply by filling out a form. However, many tax professionals are rather leery about recommending that course of action as opposed to actually creating a corporation.
- Many states do not tax LLCs the same way that the Federal government does, so be sure to find out how your own state taxes LLCs before creating one.
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