Limited liability companies (LLCs) are a popular choice for small businesses and investment activities. This guide covers the most important things to know about limited liability companies, from legal protection to federal income tax treatment.
Who owns limited liability companies?
LLC owners are called members. An LLC can have one member or many.
- Single-member LLCs have one owner. However, spouses who jointly own an LLC in a community property state can choose single-member treatment for federal income tax purposes.
- Multimember LLCs have two or more members.
Key point: LLCs are not corporations. Still, they can give their members legal protection similar to what a corporation offers.
LLCs offer legal protection
Running a business or investment through an LLC generally protects your personal assets from LLC-related liabilities. In this way, the protection is similar to that of a corporation.
After all, liabilities can arise from simple things. For example, a delivery driver might slip on your front steps. They can also arise in many complicated ways once you have employees.
Key point: As a general rule, no type of entity protects your personal assets from your own professional malpractice. Likewise, it will not protect you from your own tortious acts.
Tortious acts are wrongful deeds other than a breach of contract. One example is careless driving that causes property damage or injuries. In addition, LLC liability protection depends on state law. So talk to a qualified business attorney for details.
Single-member LLC tax basics
By default, the IRS treats a single-member LLC owned by an individual as a sole proprietorship. That stays true unless you elect to treat the LLC as a corporation.
Under the default treatment, you report the LLC’s income and expenses on Schedule C of your Form 1040. Also, if the business produces net self-employment income, you report it on Schedule SE.
- Rental. If the LLC runs a rental activity, you report the income and expenses on Schedule E.
- Farm or ranch. For a farming or ranching activity, you use Schedule F instead.
- Simple. You don’t file a separate federal income tax return for the LLC. Other things being equal, simple is good.
To sum up, here are three key points:
- The big federal tax advantage of a single-member LLC is its simplicity.
- The big non-tax advantage is liability protection under state law.
- You can elect corporate tax treatment for a single-member LLC. However, we usually don’t recommend it, for reasons we explain below.
Multimember LLC tax basics
By default, a multimember LLC is taxed as a partnership. Again, that is true unless you elect to treat the LLC as a corporation.
Under partnership treatment, the LLC must file an annual partnership return on Form 1065. Then it issues a Schedule K-1 to each member. The K-1 shows that member’s share of the LLC’s income and expenses.
Next, each member reports those amounts on their own return. For an individual, that is Form 1040. Meanwhile, the LLC itself pays no federal income tax.
This setup is called pass-through taxation. In short, income and expenses pass through to the members, who report them on their own returns. The same idea applies to regular partnerships under state law.
Electing to treat the LLC as a corporation
You can elect to treat a single-member or multimember LLC as a corporation for federal income tax purposes. To do so, you file IRS Form 8832, Entity Classification Election.
If you want S corporation status, the LLC can elect it directly on IRS Form 2553. Alternatively, it can first elect corporate treatment on Form 8832 and then file Form 2553.
There may be valid non-tax reasons to elect corporate treatment. Even so, we think tax reasons usually argue against it. After all, if corporate status is the goal, it is often simpler to incorporate from the start. And keeping your tax matters simple is generally good policy.
Possible downsides of electing corporate status
Electing corporate status for an LLC can have unexpected tax results. Here are two examples.
First, gains from selling qualified small business stock (QSBS) can be partly or fully tax-free. To qualify, you must meet strict holding period and other rules. However, whether an LLC interest counts as QSBS raises technical questions. If you want this break, setting up as a corporation from the start avoids those questions.
Second, a special rule lets you deduct up to $50,000 a year of losses on eligible small business stock as ordinary losses. For married joint filers, the limit is $100,000. Normally, such losses would be less favorable capital losses. Once again, the rule applies to stock, so an LLC interest raises questions. Forming a corporation from the start avoids the problem.
Get help choosing the right entity
Choosing between limited liability companies and corporations affects your taxes for years. We are here to help. Call us at (415) 842-2940 or book a free 15-minute call. You can also learn about our business formation service.