When first introduced as a business entity, Limited Liability Corporations were widely hailed as a great way to shield owners from personal liability for their business obligations. This “corporate veil,” as it is known in legal circles, ensures that an owner can operate a business while protecting his or her personal assets from most types of lawsuits and business debts.
Well and good, most business owners and entrepreneurs agree. But for many what it really comes down to is taxes.
Taxes are another reason why LLCs are such a popular choice of business formation. They provide for personal liability protection like the traditional corporation, but they also provide flexibility regarding tax obligations. An LLC can avoid the dreaded “double taxation” a corporation endures. In addition, an LLC can in some circumstances avoid self-employment taxes.
Which taxation option an LLC chooses depends largely upon the circumstances under which the LLC is formed:
- A Single-member LLC: With only one owner, a single-member LLC will pay taxes via the Schedule C tax form. The owner and operator of the LLC will pay income tax on the amount of money he or she made through the business, and also a self-employment tax, at least if participating in an active business (as opposed to passive activities, such as an LLC formed for investing). The owner of a single-member LLC will receive pass-through taxation. In essence, by default a single-owner LLC will be taxed as a sole proprietorship.
- A Multiple-member LLC: Just as a single-member LLC functions largely as a sole proprietorship for tax purposes, so too does a multiple-member LLC function as a partnershipregarding tax obligations. The LLC as a whole reports its income on Form 1065, with each member reporting his or her individual income on Schedule SE. Self-employment taxes are again applicable only to active businesses.
- A C-corporation LLC: An LLC can also choose to be treated as a C-corporation for tax purposes. This eliminates self-employment taxes; however, any dividends distributed to the owners will be taxed at 15 percent. An LLC electing C-corporation tax treatment is also responsible for payroll taxes if it employs workers.
- An S-corporation LLC: An LLC that chooses to be taxed as an S-corporation will have the owners pay taxes on their share of the corporation’s profit, without having to pay self-employment taxes. Unlike in a C-corporation, an S-corporation does not pay a corporate income tax. However, if an LLC owner works as an employee, the LLC must pay payroll taxes. In addition, only certain LLCs will qualify to receive S-corporation tax status.
This is a cursory introduction to the benefits and flexibility regarding the taxation of LLCs. If you are starting your own business, before choosing a business entity consult with a business formations attorney for a more thorough explanation of your options and the benefits each entity type provides.