LLC Tax Advantages and Disadvantages

The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

As far as federal income taxes are concerned, LLCs don’t really exist. The Internal Revenue Code — the body of law that outlines all federal income taxation — treats each LLC as if it were one of the other types of entities.

Specifically, unless they have elected otherwise, single-member LLCs (LLCs with one owner) will be taxed as sole proprietorships, and multiple-member LLCs will be taxed as partnerships. Because of this tax treatment, LLCs — like sole proprietorships and partnerships — are often referred to as “pass-through” entities.”

EXAMPLE: Kali owns and operates a restaurant as a sole proprietorship. She later decides to form an LLC for her business. The business will continue to be taxed as a sole proprietorship (for federal tax purposes at least).

EXAMPLE: Steve and Beth own and operate a winery. After learning about the potential dangers of unlimited liability in a partnership, they decide to form an LLC. The business will continue to be treated as a partnership for federal income tax purposes.

LLCs Taxed as Corporations

Sometimes, after forming an LLC, the owner(s) of the LLC will decide that they would benefit from being taxed as a C-corporation rather than as a sole proprietorship or partnership. When this happens, the owner(s) have two options:

1. Form a corporation and transfer all of the assets from the LLC to the corporation, or
2. Fill out a form (Form 8832) electing corporate tax treatment.

The second option is certainly the easier and less costly of the two.

The same thing can be done should the LLC’s owner(s) decide that S-corporation taxation would be beneficial. The only difference is that a different form (Form 2553) is used to notify the IRS of the election.

Disregarded Entities

If a single-member LLC does not elect to be taxed as a corporation, it is referred to as a “disregarded entity” because its existence is disregarded entirely as far as federal income tax is concerned. (That is, the LLC and its owner are considered to be one and the same.)

State Taxation of LLCs

Again, unless an election is made otherwise, LLCs will be treated as either sole proprietorships or partnerships for federal tax purposes. However, depending upon where your business is located, state income taxes might not work the same way.

For example, some states tax LLC directly on their income rather than (or in addition to) taxing the owners on their share of the income. For instance, in California, LLCs are subject to an $800 annual tax, as well as an income-based fee if the LLC earned more than $250,000 in California that year.

EXAMPLE: Braden runs a sole proprietorship in California for his part-time video production business. He earns roughly $3,000 per year from the business, and is considering forming an LLC. However, even with an annual income of only $3,000, a California LLC would still be subject to a tax of $800, or more than one-quarter of the business’s total profit. Braden eventually decides that the benefits of forming an LLC would be outweighed by this disproportionately large tax.

Before deciding to form an LLC, it’s definitely a good idea to find out precisely how your state taxes limited liability companies.

In Summary

• For federal tax purposes, single-owner LLCs are treated as sole proprietorships, and multiple-owner LLCs are treated as partnerships.
• An LLC can elect to be taxed as a corporation simply by filing a form with the IRS (Form 8832 for C-corporation tax treatment or Form 2553 for S-corporation tax treatment).
• Some states do not tax LLCs the same way that the federal government does, so be sure to find out how your own state taxes LLCs before creating one.