What is a Limited Liability Company (LLC)?

June 12, 2005 | By | Reply More

QUESTION ON All What is a Limited Liability Company (LLC)?

Editor’s Note: These questions were sent in by a reader who needed to make clarifications on the features of an LLC. Ms. Mould gives her answer and hopefully will clear the issue that Ms. Jay is trying to raise.

Q-1 Chrissie Mould’s article on S Corp vs. LLC, the author makes a grave error in stating that an LLC is a pass through entity. The LLC by itself is a C Corporation. It must make the election via Form 2553 to become an S corporation. Only the S corporation has the flow through feature. Please correct this error as soon as possible.

Q-2:If Ms. Mould is correct, tell me what form will the LLC fill out if they want to be a “pass through” entity? Let me clarify: What tax form would such an entity complete on an annual basis to reflect the “pass through” feature, I maintain that that this can only be done through a K-1 from a partnership or a K-1 from an S-corp return. My source is the Internal Revenue Service Code and Instructions to tax forms 1120S and form 1065. Of course there is also a K-1 form for a trust or and estate via form 1041 but I would be most interested in learning which K-1 form Ms. Mould had in mind.

Q-3: I read the link you provided and still maintain my position that the author of your article was so misleading in her expose of the issue that my client cited her as reference to LLC’s being pass through entities. She should have written the following in her article: “LLC can mean either a Limited Liability Company or a Limited Liability Corporation. An LLCompany is treated like a sole proprietorship and pays social security tax on earnings that appear on Schedule C and F, but ordinary income tax on Schedule E. An LLCorporation can be treated either as Partnership(LLP), in which case the earnings flow through to the individual partners’ returns OR as a C Corporation where the earnings are taxed as a regular corporation. The flow through of earnings as a Corporation can only be accomplished by filing a Form 2553 to become an S-Corporation(with an equivalent election form on the state level).” Have I made myself perfectly clear? Compare the above text to what your author has written.

– Jay, S.




ANSWER

Dear Jay,

In the United States, LLC stands for “limited liability company.” It has been mistakenly referred to by some as a “limited liability corporation”, but that is a misnomer. An LLC is NOT a corporation; rather it is an unincorporated association. An LLC is organized–not incorporated–at the state level by filing articles of organization with the appropriate state agency.

There is no such thing as an LLCompany or LLCorporation in the United States. An LLC is simply a limited liability company, i.e., a legal entity organized at the state level that generally provides liability protection for its owners against the debts and obligations of the company. The nature and degree of such limited liability protection are dependent on the statutes governing limited liability companies in the state of organization. Taxation of an LLC is a separate matter altogether.

An LLC is a pass-through entity for tax purposes, thus sayeth the IRS. Specifically, a single-member LLC is a “disregarded entity” for tax purposes and is taxed as a sole proprietorship by default. A single-member LLC that accepts the default tax classification is NOT an entity that is taxed separately by the IRS. The business profit or loss of a single-member LLC is reported on Schedule C which is attached the owner’s 1040 individual income tax return. Hence, the pass-through taxation.

A multi-member LLC is taxed as a partnership by default. Multi-member LLCs therefore file 1065 partnership returns. Ultimately, the profit or loss of such a multi-member LLC passes through to its owners (partners) in proportion to their percentage of ownership interest in the LLC. Again, pass-through taxation.

An LLC that does not wish to accept the default tax classification may elect to be taxed as 1) a corporation, by filing IRS Form 8832, or 2) an S corporation, by filing IRS Form 2553. Whether or not an S corp election needs to be made at the state level depends entirely on the state. Not all states have an equivalent S corp election form; some states simply accept the LLC’s S corp tax status based on the IRS’s approval of the election made on Form 2553.

An S corp, although it also provides pass-through taxation, can present a separate set of tax implications that is different from that of an LLC (including but not limited to differences related to capital gains, employment taxes, home office expense deductibility, and health insurance deductibility for certain owners). This not to say that one pass-through entity is better than the other overall; every situation is different and requires thoughtful consideration when selecting a business entity.

An LLC is not an LLP. Even a multi-member LLC (or “partnership LLC”, for lack of a better term) is not an LLP. LLP stands for limited liability partnership, a completely different type of business structure. The nature and degree of limited liability protection afforded by an LLP are dependent on the statutes governing LLPs in the state of registration. Some states bestow a degree of liability protection that is similar to that of an LLC, while others do not. In some states, for example, a partner in an LLP may be shielded from or indemnified against the liability resulting from the improper actions of another partner only (but not necessarily against the contractual liability of the LLP overall).

It would appear that the reader would benefit greatly from a consultation with a qualified CPA or attorney (or both) for assistance in gaining an understanding of the characteristics of the various business structures and associated tax implications. Such a consultation is particularly encouraged–strongly encouraged–if the reader is attempting to advise clients of his own on these matters. In addition to the various IRS publications, recommended reading would include Nolo.com’s discussion of the various business entities at
http://www.nolo.com/article.cfm/objectID/2C1A52D5-9364-4F92-AD191B56DF9D4CE6

Chrissie Mould

Recommended Resources on How to Form LLC:

Chrissie Mould

Chrissie Mould has over a decade of experience in business administration and startup business consulting. She has helped launch companies in multiple industries and has managed corporate administration and governance for public and private companies. She is an incorporation specialist with MyNewVenture.com LLC. The company provides low-cost incorporation services to entrepreneurs and small businesses.

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Category: Business Structure, Q & A

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