Are you planning to start a business sometime soon? Or, maybe you already own a business, that was started sometime in the last 20 years. If you’re a current or soon-to-be small business owner in the United States, chances are you’ve heard about or considered becoming a Limited Liability Company (LLC). We take a look at key characteristics of Partnerships and the tax considerations of this entity structure.
Understanding LLCs and Partnership Businesses
Organizing your business as an LLC may be a perfect match for small businesses looking for flexibility and limited liability, as the owner’s liability is limited to a fixed sum, which typically does not exceed the invested amount.
LLCs are also one of the most common ways to incorporate a partnership.
Note that while the owners of partnerships are referred to as “partners”, the owners of LLCs are technically called “members”. Some sections of this article will only refer to partners, other sections only members, and some sections will refer to both partners and LLC members. For federal tax purposes, there is normally no distinction between “partners” and “members”.
Understanding the tax make-up of LLC Partnerships
Before LLCs, C corporations used to be your only option if you wanted limited liability for your business. The C corporation structure, however, was not a good fit for all small businesses because it subjected the business owner(s) to two layers of federal tax – one at the corporate level and a second at the individual level.
S corporations were eventually created to provide relief from double taxation, preserving the C corporation benefit of limited liability while adding the feature of passthrough taxation. There were still limitations, which this article will touch on.
There was still a need for a business entity that features the limited liability protections of a corporation with the taxation principles of partnerships. At the prodding of Denver-based Hamilton Brothers Oil Company, the Wyoming legislature passed the first LLC Act in the U.S. in March 1977. It wasn’t until September 2, 1988, however, that the IRS finally gave the ok to tax LLCs under partnership taxation rules.
After the IRS’s 1988 ruling, other states began to introduce their own LLC provisions.
Offers limited liability, no ownership restrictions. As its name implies, an LLC offers limited liability to all its members. Similar to an S corporation, the owners (owners of an LLC are referred to as members, not partners) of an LLC are not personally liable for the company’s debts or liabilities. LLCs also have no ownership restrictions like an S corporation. Anyone can become a member of an LLC, including corporations, foreign individuals, and other LLCs.
By contrast, S corporation ownership is limited to U.S. citizens who are natural persons. Corporations, partnerships, and non-resident aliens are not permitted to be an S corporation shareholder.
LLCs can have one or more members. While the terms LLC and partnerships are sometimes used interchangeably, LLCs can exist with only one member. The IRS considers an LLC with one member to be a “disregarded entity.” This means that the IRS “disregards” the LLC entity and treats the business like a sole proprietorship for tax purposes. LLCs with one member are also referred to as “single-member LLCs” or SMLLCs.
Choosing the best entity structure for your business
Understanding the tax differences between entities is fundamental to your business development process. Your business entity structure directly impacts your tax obligations and should be carefully considered when considering to start a business, or when you’re wanting to change entity structure type.
Fusion CPAs understand the tax implications per entity and can look at our business needs to help you decide on the most suitable entity type for you.
This blog article is not intended to be the rendering of legal, accounting, tax advice or other professional services. Articles are based on current or proposed tax rules at the time they are written and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.
