Businesses can have many different types of legal organization and one of the most common types is the Limited Liability Corporation (“LLC”). This type of legal organization is favored by many small businesses as they are fairly easy to setup and they give a lot of flexibility to the owner(s). However, there are a lot of misconceptions and misinformation about the LLC and this article will help clear up some of the confusion and provide the basics on Limited Liability Corporations.
Limited Liability Corporations are state sanctioned corporations that are commonly used to start small businesses or create legal protection. LLCs, as the name suggests, give members (the term used for owners) of LLCs limited liability protection meaning that the liabilities of the corporations only extend to the capital invested into the LLC by the members. This limited liability provision is similar to the limited liability provisions given to shareholders by corporations. The terms of the LLC can be broad and flexible, so you can have different classes of membership and can structure the ownership as desired.
The legal aspects of LLCs are fairly straightforward, however, the tax implications of LLCs are complicated and is where there is a lot of confusion. As stated above, the LLC is a state sanctioned corporation. Therefore, when it come to the IRS, you have some flexibility as to how you are taxed. By default, a single member LLC (meaning an LLC with one owner) is disregarded for tax purposes and therefore shares the same taxation as a sole proprietorship. Thus, by creating a single member LLC, there is no change in taxation. LLCs with two or more members are considered to be a multi-member LLC and has a default tax classification as a partnership and would report its taxation on Form 1065. Both default classifications by the IRS are pass through classifications, meaning that the taxes owed by the LLC are paid for at the individual tax return level. The flexibility the IRS grants to LLCs is that they can disregard their default tax classification by making elections to be taxed as an S-Corporation or a C-Corporation and each of those has their own tax considerations that would need to be considered before doing so.
A common misconception about LLCs is that by forming one, you get special tax savings by forming an LLC. This, on its face, is simply not true. The LLC exists more so as a legal determination for forming a corporation rather than a taxation determination. By forming an LLC, you are granting legal protection to the business and the owners of the business. The methods of taxation for an LLC are similar to other legal forms of organization because the LLC has the ability to make an election to its preferred form of tax classification. Therefore, formation of an LLC should not be done based on “tax savings” or taxation determination.
Making a determination to form a corporation, whether it is an LLC, S-Corporation, or C-Corporation should be done first as a way of legal protection. Once, from a legal perspective, you have determined what type or types of legal organization make the most sense, then you should determine what makes the most sense from a tax perspective. None of the forms of legal organization can make the claim to provide specific tax savings. The actual taxes you pay are based on the health of your business and whether it is paid at the corporate level or passed through to the individual.
Limited liability corporations are a great way to form a legal corporation and provide lots of flexibility that other legal organizations do not. However, from a tax perspective, LLCs are not a magical wand you can waive to pay less taxes. Creating an LLC from a tax perspective only is not a wise way to start a new business.