During this past tax season, I had a conversation with a frustrated CPA. The frustration primarily arose from several of her clients not knowing how their limited liability company (“LLC”) was classified for tax purposes. This article provides a brief overview of the taxation of LLCs that will hopefully provide a bit of knowledge to small business owners and eliminate some of the frustrations that taxpayers and tax professionals experience during tax season.
When forming an entity at the state level with the given state’s Secretary of State, there are several entity options to choose from. One of those options is the very popular choice of LLC. LLCs were created to provide the best of both worlds between corporations and partnerships/sole proprietorships. The LLC provides members limited liability protection similar to that of corporations that is not available to those organized as a sole proprietorship or partnership, while also allowing members to escape the double taxation and corporate formalities that corporations face.
However, the IRS does not recognize “LLC” as a way for an entity to be taxed. No member of an LLC can say that their LLC is “taxed as an LLC.” All LLCs must make a choice of how to be taxed from the three options, or the IRS will assign a default option to the LLC according to how many members are in the LLC. For LLCs with only one member (single member LLCs), the LLC has the following three options to select from: (1) a disregarded entity, meaning that the LLC will be treated as a sole proprietorship for tax purposes and all of the LLC’s revenue and expenses will flow through to Schedule C of the member’s IRS Form 1040 Tax Return (this is the default selection for single member LLCs); (2) an S-corporation; or (3) a C-corporation. For LLCs with two or more members, the choices change slightly. A multiple member LLC has the following three options to select from: (1) taxed as a partnership (this is the default option for multiple member LLCs); (2) an S-corporation; or (3) a C-corporation.
It is very important for members of an LLC to know how their LLC is taxed, and this will be one of the first questions asked by a tax professional preparing their entity’s tax return. If the members of an LLC have never made a selection for how the LLC shall be taxed, then the LLC is taxed according to the default selections listed above. If the members have made a selection to be taxed other than the default selections, two things become very important: (1) that the member(s) know what selection has been made; and (2) that the member(s) are certain that such an election was filed with the IRS. Many times, members of an LLC believe that such an election has been made while the proper form for making such selection has never been filed with the IRS.
The failure to file the election may happen for several reasons. Sometimes members simply do not realize that a form must be filed in order to make such an election. Other times, there is confusion between the member, the member’s CPA or other tax professional, and the member’s attorney on who should file the election. Who files the election is not nearly as important as the election actually getting filed. Members should always ensure that the responsible party for filing the form knows that they are the responsible party.
Frustration arises when the tax professional asks the member how their LLC is taxed, but the member either has no idea how the LLC is taxed, believes that the LLC is taxed as an LLC, or tells the tax professional that the LLC is taxed one way but no election has ever been filed. Hopefully this article provides some basic knowledge of LLCs and how they are taxed in order to eliminate a small portion of the frustration experienced by many during tax season. If you have questions as to which election will be most beneficial for your LLC, feel free to give Van Osdol, PC, a call. We have attorneys who will gladly walk you through the pros and cons of each option.
(Bobby concentrates his practice in the areas of business law, corporate law, and taxation issues. He assists clients with business formation, choice of entity decisions, contracts, tax planning, and general corporate needs.)
