Incorporating as a Limited Liability Company, or LLC, has been gaining in popularity over the past several years. However, what many people do not realize is that when an LLC is formed, the taxation of that entity and its members is not automatically specified. The IRS allows the LLC to be taxed in a variety of ways, depending on the number of members in the LLC and the wishes of the members. Here are the basic rules:
If the members of an LLC do not choose a particular taxable form, they will fall into what the IRS calls a "default classification," which is based upon the number of members in the LLC. The default classifications are described below.
- Single Member LLC--In a single member LLC, the default classification will be a "disregarded entity." In this case, the IRS taxes the LLC as a sole proprietorship, which means the member will report the activity of the business on a Schedule C, F, or E, depending on the nature of the business. This schedule, which shows the activity of the LLC, would then be attached to the member's personal tax return. This format is generally the easiest to understand for new business owners, as they can move personal funds into and out of the business as necessary with no penalties or tax consequences.
- Multi-member LLC--For an LLC that has more than one member, the default classification is partnership. In partnership taxation, the net income of the partnership is divided among the members according to their membership interests or percentages of ownership. Members do not normally draw a salary, but they can draw set amounts, referred to as "guaranteed payments."
If the member(s) of an LLC do not desire to be taxed under one of the default classifications, it can elect to be taxed as a corporation or as a Subchapter S corporation. Form 8832 is used to make this election in the case of a "C Corporation" (also referred to as a "regular" or "normal" corporation). If the LLC chooses to be taxed as an "S Corporation", the Form 2553 is used to make the election.
- In the basic corporate format, or a "C Corporation", the corporation is a taxable entity separate from the members. In this situation, the member(s) will be compelled to draw a salary, and will receive a Form W-2 at the end of the year. If the member begins drawing additional funds from the corporation, they will be reported as dividends. This is not a good situation, as dividends are often referred to as "double taxed". The member must pay personal income taxes on the dividends, and the LLC/Corporation cannot deduct the dividends as an expense, so the corp is paying taxes on those amounts as well.
- If the members choose to be taxed as an S Corporation, the company pays no taxes of its own. Instead, the net income of the LLC will flow through to the personal tax return of the member(s), and will be reported on Schedule E. There is a misconception that, with an S Corporation, funds can be drawn out of the corporation with no taxable consequences. However, this is not the case. While the rules are a bit more relaxed, the member would still need to draw a salary and be treated as an employee, because the IRS views all corporate officers as employees.
Change in Default Classification
If the original circumstances of the LLC change, the default classification changes as well. If an LLC originally treated as a disregarded entity gains another member, the classification automatically changes to a partnership. The reverse is also true. If an LLC with only two members loses one member, it defaults back down to a disregarded entity. Corporations, S Corporations, and Partnerships with more than two members would not need to change their classification due to losing or gaining a member.
If an LLC chooses to change its classification, it cannot choose to change it again until after 60 months, or 5 years, have passed. An election made by a newly formed LLC is not a change that falls into these rules.