LLCs are becoming popular because of their advantages. But how are they taxed?
Limited liability companies (LLCs) are a newer business entity option than the traditional ones like sole proprietorship and partnership. It is unique from all the others as it does not originate via the Internal Revenue Code. State statutes govern the formation of LLCs and there is a lot of variety in how this entity is formed from state to state. There are even a few states where this entity type is not permitted.
LLC owners have limited liability and will generally not lose personal assets due to a business lawsuit. Most states do not restrict membership which allows corporations, individuals, and even foreign business entities to become members. There is usually no limit as to the number of members allowed. Some states even permit one person to form an LLC that is commonly referred to as a single-member LLC.
How Is Your LLC Taxed?
Now we have a problem as the Internal Revenue Service (IRS) did not provide information about how to tax the entity originally. So we have an interestingly unique set of rules. The LLC is the only business entity that does not have a tax return unique to its entity type. Rather, the LLC uses an existing form from one of the other entity choices. So the LLC may choose whether it is taxed as a partnership, corporation, or sole proprietorship for federal income tax purposes.
The Options and Rules
A single-member LLC has the choice of an association taxable as a corporation or a disregarded entity. A disregarded entity simply means the IRS does not recognize the LLC for federal income tax purposes. So the LLC would operate as a sole proprietorship for federal income tax purposes. The annual federal tax return would be filed via Schedule C as part of the owner’s annual Form 1040 filing.
A multiple-member LLC has two options for federal income tax purposes. An association taxable as a corporation or a partnership is the choice.
Your LLC may choose not to pick its federal taxable entity. If no choice is specified, the default entity for each LLC type has been defined by the IRS. For a single-member LLC, the default entity is a sole proprietorship (also known as the “disregarded entity” option). For a multiple-member LLC, the default entity is a sole partnership. If an LLC desires to use the default entity when they are first formed, no special election is required.
A single-member LLC desiring to file as a corporation must use Form 8832 Entity Classification Election to make an election to do so. A multiple-member LLC also uses the form to elect to be taxed as a corporation. If an LLC has been operating and filing tax returns as one entity type and chooses to change to another entity type for federal income tax purposes, Form 8832 is used to change entity types. For example, if your single-member LLC has been operating as a sole proprietorship for three years and you want to be a corporation, you will need to file Form 8832 to change to a corporation for federal income tax purposes. The form must be used even, as in the example, if you were operating as a default entity originally.
The form requires some LLC information to be entered, including name, address, and employer identification number. There are several pages of questions and entity choices that require navigation. The form instructions are good, but help from a tax professional may be required. Signatures of all the members are also needed.
The form filing is subject to IRS approval. You will generally be notified with 60 days of the original filing. If return mail is not received by the end of two months, follow up should be done.
If your business becomes an LLC, you should explore your federal income taxing options. You can arrange tax training for your financial staff via CPE Hours. What you choose to be may greatly affect other aspects of your business operations. If you do not choose, a default taxing entity will be designated. But the choice to become that default entity should be your choice, not that of the IRS.