How an LLC is Taxed

How an LLC is taxed is a complicated question. This is because an LLC doesn’t have a unique “tax structure” under the IRS code. Corporations and partnerships have their own tax structures, but an LLC does not. An LLC is not a partnership or a corporation. An LLC is a unique business structure called a limited liability company.

The confusion in how an LLC is taxed is understandable. When the LLC was first created in Wyoming, the people who were pushing the Wyoming legislation asked how the IRS wanted to have it taxed. It took almost 20 years for the IRS to answer this question. The LLC is actually a defective corporation and the IRS didn’t know whether to tax it as a corporation. The LLC is not a partnership either, so technically it couldn’t be taxed as a partnership. The IRS could have created another section of the code describing specific taxation rules for the LLC, but they didn’t. The IRS simply said that they would let the LLC owner decide how to be taxed. Now this was ground breaking. How often does the IRS give you a tax choice?

So now under the IRS code you make your own choice on how an LLC is taxed. The best way to know what you should elect is to understand your options. You can elect to be taxed as either a sole proprietorship, partnership or a corporation. In a partnership tax election, partners divide up the profits and losses based on the percentage ownership they have in the partnership. They send out notices called K1’s to each partner, telling them what their share of the profit or loss is and then each partner pays their own taxes.

Corporations also actually have a tax choice. If you have a corporation, you can be taxed under either subchapter C or subchapter S of the IRS code, you get to choose. Subchapter C of the IRS code is generally the election the traditional corporations like IBM, Bank of America, and all the big boys make. The C Corporation pays its own taxes directly to the IRS. The owners then pay tax on the money they get from the company. This can result in a double taxation and hurts the small company owner.

Subchapter S of the IRS code is for smaller companies. This section taxes the corporation like a partnership would be taxed. The S corporation has to file a tax return, but then the actual earnings or losses “pass through” on a K-1 to the owners of the corporation and are actually “recognized” by the owners pro-rata based on their ownership interests.

Understanding how the partnership and corporations are taxed, you are ready to make your own choice on how an LLC is taxed. If you are the only owner, you do not make an election, your LLC will be taxed as a sole proprietorship, or you can make an election to have it taxed as an S Corporation. If you have multiple owners and you do nothing, your LLC will be taxed as a partnership. You can make an election and have your LLC taxed as a corporation (either C or S). To make an election you must file the appropriate papers with the IRS. Here is a link to the information. Your LLC is one of the best tax saving devices you can have, so it is important to make the right choice. The bottom line is you choose how you want your LLC to be taxed and you should make an informed choice.

How an LLC is taxed does not make a difference in how the LLC functions. It will still have the same liability protection, operate as easily and have the double asset protection and everything is the same. To put it a different way, the legal structure of your LLC is the same no matter how you choose to have your LLC taxed. There is no such thing as a limited liability partnership, or a limited liability corporation. There is only a limited liability company taxed as either a partnership or corporation.

As I mentioned, an LLC is basically a defective corporation. And you get to choose how it is defective. In the standard internet forms, and even the standard law office forms, the assumption is made for you as to how you want your LLC to read. You can play tricks with the LLC by making it defective in different ways. My “Complete Operating Agreement” will walk you through the tricks. It will teach you everything about the tax benefits and asset protection of an LLC. The bottom line is that how an LLC is taxed is up to you. You can make a tax election that will be best for your company.

By Lee R Phillips