As I write this article, it’s Tax Day, April 15th, 2024. Tax professionals around the world rejoice as we get a natural break from the craziness of the last few weeks. Despite our best efforts to smooth out work with tax extensions, this week is always a rush. Last minute pieces of information are being received and clients are signing off on e-file authorizations.

A common theme I hear from our team are the surprise LLCs that pop up this time of year. Surprise for us as a tax professional (hint: it can greatly impact your tax liability or tax preparation fees!). Surprise from clients when we tell them how their choice of entity impacts their tax return.

Spoiler: Contact your tax professional before establishing an LLC!

What is an LLC?

LLC stands for limited liability company. A limited liability company is a State level business structure. It protects the assets of its owners from lawsuits and creditors concerned with the company’s business debts.

The important thing to note is the LLC is a State level designation. As we’ll see later, an LLC can turn into any number of IRS tax filings depending on the ownership structure.

While an LLC is designed for asset protection, you should always ensure that you have appropriate levels of insurance for whatever the business is doing. Consider property insurance, riders on your homeowner policy, auto insurance, Errors & Omissions insurance, or other occupation specific insurance first. 

Your LLC is meant as the protection of last resort to protect your personal assets from a lawsuit against the business. Keep in mind that if you have a smaller business and it is reliant on your services, it may be hard to insulate yourself from a lawsuit. Having an appropriate umbrella insurance policy in place can help. See your insurance agent for more details.

How Can an LLC Protect You?

You can think of an LLC as a protective wrapper around your business. The wrapper only works if you treat transactions to and from the LLC appropriately. If you use your business as a personal checking account, the LLC will undoubtedly provide little protection to your personal assets. 

In order to receive the protection from the LLC, you’ll need to completely separate your business and personal checking accounts, credit cards, etc. and ensure that you don’t pay for personal expenses out of the business.

There are numerous court cases that have ruled for the plaintiff, allowing them to “pierce the veil” of the LLC and attack the owner’s personal assets. You don’t want to be one of these cases!

How the IRS Views LLCs

So how exactly does the IRS tax LLCs? 

Answer: it depends!

What makes LLCs great is that they are flexible for tax purposes. Which also makes them confusing for our clients.

The tax treatment of LLCs comes down to two factors:

  1. The number of owners of the LLC
  2. Whether an election has been made with the IRS to treat the LLC differently

Let’s talk about the number of owners first.

By default (with no elections being filed), the IRS will treat LLCs as either a disregarded entity or a partnership. LLCs with one owner are a disregarded entity. Multiple owners is a partnership.

LLCs that are disregarded are treated no differently for IRS purposes than a sole proprietorship. The activities of the LLC are simply reported on your personal tax return on either Schedule C for self employment or Schedule E for rental activities.

As soon as you add an owner, you have created a partnership for tax purposes. Partnership returns are inherently more complex and require a completely separate business tax return filing (Form 1065).

This includes a married couple having 50% ownership each! Many of our clients are (unhappily) surprised to learn that by sharing ownership of the LLC their tax fees went up by 2X! There is a narrow exception for clients living in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin). These states will allow the LLC to be disregarded even with the married couple sharing ownership.

Now let’s talk about IRS tax elections.

The IRS also allows owners of LLCs to make a tax election to treat their LLC in a different way for tax purposes.

IRS Form 2553 allows the LLC to elect S Corp tax status. The timely filed election is due March 15th (although late elections are generally accepted all the way up until the filing of the tax return).

An S Corp election can be filed regardless of the number of owners. S Corporations are required to file Form 1120S with the IRS on a separate business return.

S Corporations can be a powerful tax savings tool, but not for everyone. We run comparisons for our clients to determine if the S Corp can save money. This type of entity structure requires the owner to be on payroll, so it is important to run the numbers before making the election due to the extra tax compliance costs involved.

It’s also important to note that many states (looking at you, California…) require separate entity level LLC filings, even if you’ve chosen to keep your LLC as a disregarded entity. Be sure to review your state and local tax filing requirements before jumping in head first with an LLC.

And, if your head is spinning, and you think an LLC might be right for you, please contact us with questions before making a final decision. An ounce of prevention is worth a pound of cure.

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