Limited Liability Companies & Entity Classification

Many clients are referred to our office with questions about the Limited Liability Company (LLC). Their questions range from: “What is it?” to “How does this affect me?”. Perhaps the most puzzling is the question of entity election: Should I be a Sole Proprietorship, Partnership or Corporation? Since the name of the entity includes the letters LLC, which stands for Limited Liability Company, doesn’t that mean I’m a Company or a Corporation? Why should I have to elect an entity classification?

How LLCs are taxed

So what am I?

The Massachusetts Limited Liability Company law became effective January 1, 1996 with the creation of the Limited Liability Act. An Limited Liability Company is a form of business organization that is unincorporated and having one or more members formed pursuant to Massachusetts General Law chapter 156C.

That’s just the legal definition. The Internal Revenue Service does not recognize the legal definition; therefore it is possible to tax an LLC as a┬áSchedule C, Corporation, S Corporation, or Partnership. These options can be daunting.

I will start with explaining the automatic tax treatment by the IRS and then Tax Elections that are available. An LLC can have one or several members. The IRS automatically taxes the LLC as a Sole Proprietor if one member; as a Partnership if two (or more) members. Therefore, you must be extremely careful when applying for a tax identification number as this information allows the IRS to assign a tax filing category in their computer systems. In both situations the profit of the LLC is taxed with your individual tax return. This means that the profit of the LLC is subject to federal income tax, self-employment tax (subject to Internal Revenue Code (IRC) limitations), along with Massachusetts income tax.

There are Tax Elections available for an LLC member or members to make with the IRS to have the Organization taxed as a Corporation or S – Corporation. To be treated as a Corporation you must file an Entity Classification Election Form with the IRS. To be treated as an S Corporation you must file an Entity Classification Election Form along with Election by a Small Business Corporation (pursuant to IRC 1362). I recommend mailing the executed Forms to the IRS certified and return receipt to prove timely mailing and IRS will stamp receipt of the Form. The IRS will then issue an approval letter, confirming whether the elections have been granted. You must retain a copy of this letter for as long as the LLC is active.

This process appears confusing on its face. However, if you think of the process in terms of how you want to be taxed and what Form you desire the LLC to file, that will provide you with the road map of Forms you must file with the IRS to accomplish your goal. Remember, choosing the correct tax treatment of your LLC will cost you thousands of dollars or save you thousands of dollars.

Once you have completed the election(s) that you believe are appropriate for your particular tax situation, you are now ready to engage in a profitable business year and file the Tax Return that will yield you the least tax liability! Now that is tax music to my ears.



Posted by Terranova & Associates LLC

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