Tax Advantage of an LLC

By Jeff Franco J.D./M.A./M.B.A.

The Internal Revenue Service does not provide a specific set of federal income tax rules that apply solely to limited liability companies. Rather, the federal tax law automatically designates new single-member LLCs as sole proprietorships for tax purposes and disregards the legal business entity. An LLC that has more than one member receives automatic partnership designation for tax purposes.

Flexibility

A notable advantage of creating an LLC is that the federal tax law affords members great flexibility in choosing the type of tax rules to apply to business income. If you prefer to alter the IRS default designations, you can make an election on IRS Form 8832 to change the applicable tax rules. If the IRS designates the LLC as a partnership, you can change it to a corporation. A sole proprietorship can elect corporate tax treatment, and a corporation is eligible to change back to a partnership or sole proprietorship. However, an election is binding for 60 months before you can make a new election. The 60-month period requirement does not apply to IRS default designations.

Double Taxation Avoidance

Although a corporate structure may be advantageous for some businesses, corporate tax rules impose a double taxation that does not apply to other business entities. The corporation is a separate taxpayer that is solely responsible for reporting taxable income and making tax payments. The second level of taxation is relevant when the company distributes dividends to its shareholders. Tax is already paid on the earnings from which the dividends are paid, but the shareholder must again report dividends as taxable income on a personal tax return. Forming an LLC provides similar non-tax benefits as a corporation, but allows you to elect a less burdensome tax regime. If you choose to designate the company as a partnership or sole proprietorship, it is the individual members who pay tax on their proportionate share of business earnings. A tax is not imposed at the business entity level.

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Tax Reporting

Tax reporting requirements for certain business structures can be time consuming and expensive. For example, a corporation must file a tax return each year, regardless of whether the business is active or has any earnings. However, if you choose to create a business as an LLC, you can choose the tax rules that provide the most convenient reporting requirements. If a sole proprietorship or partnership does not have income during the tax year, the IRS does not require you to file business returns.

Liability

If the LLC has multiple members, choosing tax rules that limit individual member’s liability to make tax payments may provide an effective asset protection strategy. For example, if you create a corporation rather than an LLC, the corporate entity must remit tax payments, and shareholders are protected from liability if the IRS imposes penalties and interest on the corporation. However, the investment they contribute to the corporation is vulnerable to seizures and liens by the IRS, irrespective of who is responsible for noncompliance. Alternatively, you can elect partnership or sole proprietor status, making each individual member responsible for tax payments only on their proportionate shares. Your personal assets and investment are not at risk if another member defaults on tax payments.

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What Tax Forms Are Needed for an LLC?

References

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