“What is an LLC?” That is a question I almost never hear, and yet it seems more than half of new clients seem to have confusion over legal status and tax status. Legal status refers to legal entity status. That is, “is it separate from it’s owners or, is it just an alter ego of the owners”, and what rules of law govern and define it. Tax status is just how you will be taxed under federal and state law.
Consider the LLC. For simplification purposes think of an LLC like a building. That building can be many things, like an office, a warehouse, apartments or retail space. It all depends on what you elect to do with it.
If the LLC has one owner it is, by default, a disregarded entity. Most tax issues are treated as if there is no business entity. The activity and income are reported by the owner on a schedule C. For tax purposes the LLC is just and alter ego of the owner. For legal purposes (more or less) it is a separate business and separate from the owner.
If the LLC has multiple owners it is, by default, taxed as a partnership and generally has to follow partnership tax rules. A partnership tax return must be filed and owners get the income or loss on their tax return. Partnership basis limitations apply. For tax purposes this LLC sings and dances like a partnership.
With single or multiple ownership, and timely election, the LLC can be taxed like a C-corporation or an S-corporation. With the election, all the accompanying tax rules and responsibilities follow.
In short, “What is and LLC ?”. An LLC is just a generic business entity that has legal status as separate from its owners. What you do with it for tax purposes is up to you. There are defaults which may not leave you in the best tax position and should be addressed, generally before 2 ½ months after formation.
Please be aware that legal status and its maintenance are important legal issues and the advice of an attorney should be sought. The above is for general information purposes and should not be considered legal advice or tax advice. When necessary consult with a CPA about your specific situation.
An S-Corporation is a tax status created by the tax code that determines how a business will be treated for taxation purposes. It is just a tax election that can be made by Corporations, LLCs and even Partnerships.
In a nut shell, a business’s taxable income & loss “passes” from the entity to the owners so it is taxed only at the ownership level. Note that the passing of income is for tax purposes only and has nothing to do with actual cash or asset distributions.
Another potential tax advantage comes to partnerships and LLCs that make the election is potential reduction of self-employment tax. In this case the owners can hold two positions relative to the business; that of employee and, that of investor. As an employee, the shareholder must draw a reasonable salary and payroll taxes must be paid and tax returns filed. The rest of the income passes through as investment income thereby reducing total employment tax. Fortunately reasonable does not preclude an aggressively low manager’s salary, enhancing the potential benefit.
This beneficial position is not without cost and responsibility. To claim owner’s salaries, they must be paid and taxes withheld and employment tax returns filed as with all employees. While aggressively low can be acceptable, $0 salary is not. Additionally losses in excess of basis present a problem as do owner’s distributions in times of loss. For the S election to be effective the proper forms must be filed (2553 or 8869) timely and there are ownership restrictions.
In short, an s-corp. can have some marvelous tax benefits but each situation needs to be looked at with your CPA and the pro’s and con’s weighed.