Understanding LLCs

What is an LLC?

A limited liability company (typically called an LLC) is a type of business entity that combines the limited liability protection of a corporation but with greater flexibility and typically lower costs. In an LLC, owners are referred to as members, and the company is managed either by the members themselves or by managers appointed by the members.

LLCs are a popular choice for small businesses, as they are relatively easy and inexpensive to set up and maintain. However, LLCs are state-level corporations meaning that for tax filing purposes, LLCs must declare to the federal government how they will be treated for tax purposes. Read on to learn more about the benefits of setting your business up as an LLC.

Why is it Beneficial?

There are several advantages to forming an LLC, including:

• Limited Liability Protection: The personal assets of LLC members are typically shielded from the debts and legal obligations of the business. In the event of lawsuits or financial difficulties, creditors generally cannot pursue the personal assets of individual members to settle business debts.

• Variable Tax Status: One of the key advantages of forming an LLC is the flexibility it offers in selecting a federal tax status. Unlike corporations, LLC owners can choose how they want to be taxed for federal income tax purposes. By default, single-owner LLCs are treated as disregarded entities and taxed as sole proprietorships, while multi-member LLCs are taxed as partnerships. However, LLC owners can elect to be taxed as an S corporation or a C corporation by filing the appropriate forms with the Internal Revenue Service (IRS). This flexibility allows LLC owners to select the tax status that best suits their business needs and financial goals, potentially leading to significant tax savings.

• Ability to Change Federal Tax Status: Another important aspect of an LLC's federal tax status is the ability to change it as your business evolves. As mentioned earlier, LLCs can initially choose their preferred tax status, but they are not locked into that choice permanently. If an LLC's circumstances change or if the owners determine that a different tax status would be more beneficial, they can file the necessary paperwork with the IRS to update their tax classification. However, it's important to note that there is a limitation known as the "five-year limitation rule" when changing taxation status. According to IRS regulations, an LLC can only change status once every five years. For example, if you elected to be treated as an S corporation in 2023, the earliest you could change status would be 2028.  

How do I Create an LLC?

You can create an LLC by following these steps:

1. Choose a Name: Select a unique business name that complies with your state's regulations for LLC names. Typically, the name must include the abbreviation "LLC" or "Limited Liability Company" to indicate its legal structure.

2. File Articles of Organization: Submit articles of organization (sometimes called a certificate of formation or similar document) to the Secretary of State or similar agency in your state. These articles outline essential details about the LLC, such as its name, principal place of business, registered agent, and management structure.

3. Create an Operating Agreement: While not always a legal requirement, drafting an operating agreement is highly recommended for LLCs. This document outlines the ownership structure, management responsibilities, decision-making processes, and other important aspects of the LLC's operations. It helps clarify the rights and obligations of the members and can prevent disputes in the future.

4. Obtain an Employer Identification Number (EIN): Apply for an EIN from the IRS, which is used to identify the LLC for tax purposes. This can be done online through the IRS website. The EIN serves as the LLC's tax identification number and is necessary for opening bank accounts, hiring employees, and filing taxes.

5. Elect Federal Taxation Status: LLCs can choose how they want to be taxed for federal income tax purposes. By default, they are pass-through entities. They can also elect S Corporation status to potentially reduce self-employment taxes or opt for C Corporation status for different tax planning opportunities. Single-member LLCs have the option to be taxed as sole proprietorships.

What is important to consider when electing my federal taxation status?

By default, LLCs with one owner are treated as a disregarded entity and as you just saw, an LLC can also opt to be treated as a partnership (called a multi-member LLC), S corporation, C Corporation, or sole proprietorship if they are a single-member LLC. Here are the main options and what you need to know about each:

Single-Member LLC (treated as a sole proprietorship): If your business only has one owner and has relatively low profits or your business operations are straightforward, sticking with the default taxation as a sole proprietorship might be the simplest choice. This option requires no formal election and involves reporting your LLC's income and expenses on your personal tax return using Schedule C. While this approach offers ease of administration and minimal paperwork, it may result in higher self-employment taxes for the owner as profits increase, and there's less flexibility in structuring income for tax efficiency.

Pros: Easy to understand; your business's profits and losses go on your personal tax return, so you don't pay taxes twice.

Cons: You'll pay self-employment taxes on everything you make, and it's harder to save on taxes.

How to Do It: You don't need to do anything special; this is how it works unless you choose something else.

Multi-member LLC (treated as a Partnership): If you have one or more owners, the default tax classification is as a partnership. Under this structure, the LLC itself does not pay income taxes. Instead, each member of the LLC reports their share of the company's profits and losses on their personal tax returns using Schedule K-1. This option allows for flexibility in allocating profits and losses among members, which can be advantageous for businesses with multiple owners who have different levels of involvement or investment in the company. However, members will likely still be subject to self-employment taxes on their share of the LLC's income.

Pros: Flexibility in allocating profits and losses among members; avoids double taxation; allows for special allocations of income and deductions.

Cons: More complex tax filing requirements; members will likely be subject to self-employment taxes; potential for disagreements among members regarding profit and loss allocation.

How to Do It: No formal election is required; this is the default tax classification for multi-member LLCs. However, the LLC must file Form 1065 (U.S. Return of Partnership Income) and provide each member with a Schedule K-1 showing their share of the LLC's income, deductions, and credits.

S Corporation (Form 2553): Opting for S Corporation status can be beneficial if your LLC generates significant profits and you're looking to minimize self-employment taxes. By filing Form 2553 with the IRS, your LLC can be treated as an S Corporation for tax purposes. This election allows for potential tax savings since only the salary portion of the income is subject to self-employment taxes, while the remaining profits can be distributed as dividends. However, S Corporation status comes with eligibility requirements, such as limitations on the number and type of shareholders and entails additional administrative responsibilities like holding regular shareholder meetings and maintaining corporate records.

Pros: You might save money on taxes because you don't have to pay self-employment taxes on all your income.

Cons: More paperwork, and there are rules about who can own your business.

How to Do It: Fill out Form 2553 and send it to the IRS to choose S Corporation status.

C Corporation (Form 8832): If your LLC plans to reinvest profits into the business for growth or expansion, or if you have complex ownership structures or are seeking outside investment, choosing C Corporation status might be advantageous. By filing Form 8832 with the IRS, your LLC can elect to be taxed as a C Corporation. While C Corporation status may result in double taxation—taxes paid at both the corporate and shareholder levels—it offers benefits like lower corporate tax rates and flexibility in structuring compensation and benefits. However, there are additional administrative requirements associated with C Corporation status, such as holding annual shareholder meetings and adhering to corporate formalities.

Pros: You might pay lower taxes, and there are some ways to manage your money that could save you even more.

Cons: You might end up paying taxes twice, once on your business's profits and again on the money you take home.

How to Do It: Fill out Form 8832 and send it to the IRS to choose C Corporation status.

When you're deciding, think about how much money your business will make, who owns it, and what you want to do with the money. To learn more about your options, see our guide on Incorporation.

Regardless of the option you choose, it's important to know that you're not locked into that taxation status forever. As your business evolves and your circumstances change, you can revisit your taxation status and adjust accordingly. If your situation shifts, such as experiencing significant growth or changes in ownership structure, you can always update your taxation status to better align with your current needs and goals every five years.

To learn more, contact a tax professional, business coach, or visit the IRS website.