What Kind of Critter is an LLC?

Lara Croft? Lemon Lime Centerpiece?  What does it mean when a business name ends in "LC" or "LLC," anyway?

It means that the company is a "limited liability company."  This type of business format made its U.S. debut in Wyoming during the Reagan administration, but LLCs really took off in 1996 after the Treasury spelled out the often convenient tax consequences of these critters. 

In short, they allow taxpayers to have many of the state law benefits of corporate form - such as protection of owners from personal liability for the entity's actions - without the inconvenient tax consequences of corporate form.  Or to put it another way, they provide the tax benefits of partnerships or sole proprietorships along with a layer of liability protection.

What are these tax benefits when an LLC has multiple owners?  They are general tax benefits of the partnership format.  It's usually possible to get assets in and out of a partnership tax-free; it's much more difficult to do so when working with a corporation.  Owners get to include their share of LLC borrowings in their basis, which can provide extra deductions in the right circumstances.  Corporations can have joint ventures with LLCs without incurring the extra level of corporate tax they might otherwise have.

The Tax Nothing

An LLC with only one owner is a "disregarded entity" for tax purposes.  It's treated as if it didn't exist; the LLC owner is treated for tax purposes as if he owns the assets directly   If your single member LLC owns a business, you just report it on your schedule C; if the LLC is a landlord, you use Schedule E; and if it owns a farm, it goes on schedule F.  That means the LLC doesn't require a separate tax return. 

The mystery of the missing LLCs

Even with these advantages, LLCs still haven't taken the world by storm.  IRS statistics show that S corporations are more popular.  There are several reasons for this:

- LLC owners are treated as partners for employment tax purposes.  That means they aren't supposed to get W-2s and withholding; instead their compensation is supposed to be "guaranteed payments."  That means the owners are supposed to pay quarterly estimated tax payments instead of having taxes withheld, and the income is reported on a K-1, rather than a W-2.  Many owners don't care for this.

-While there is uncertainty on this score, an LLC owner who works for the LLC is likely to face self-employment tax on all of his share of LLC income - not just his "salary" or "draw."  While S corporation wages are subject to the usual employment taxes, S corporation earnings reportable on the K-1 are not subject to SE tax. 

- While partnership taxation is more flexible, it can also be more complicated. That's great for us tax geeks, but not so much for actual taxpayers.

- Owners of Iowa S corporations that do business in other states are eligible for a tax credit based on sales outside of Iowa.  This credit is unavailable to LLCs.

LLCs are most common when self-employment tax isn't an issue - for example, in rental real estate or corporate joint ventures.  They are also great for situations when an S corporation isn't possible - for example, when an individual or an S corporation wants to enter into a joint venture with a C corporation.  They're an important part of your tax pro's toolkit, and you'll be seeing more of them.

Comments

[Rush Nigut]

Excellent overview of the tax ramifications of LLCs. I know it always depends on the specifics but where do you generally fall down on the S corp v. LLC issue? What are the most important factors that influence your decision one way or the other?

[Joe Kristan]

Rush, in most cases the deciding factor is the nature of the business and the ownership. If you have a non-real estate business with multi-state activity, that usually pushes you into an S corporation. Real estate businesses or joint ventures with corporations generally do best as LLCs.