One of the biggest benefits of running a business through a limited liability company is the automatic qualification of pass through taxation. Unlike an S corporation which requires that certain conditions be met and maintained in order to get pass through taxation, an LLC automatically provides this.

Why is this better than other tax options?

Well, it is not better in all cases. Some businesses are better off with corporate taxation and the ultimate decision depends on each case, but in most small business cases, pass through taxation wins out.

Here are some fundamental basic attributes:

1. Profits made by the business are passed through to the owners so the LLC itself does not pay taxes on profits. This avoids the double taxation of the corporate tax structure and often allows owners to keep more profits.

2. Losses are passed through. Generally, if a business generates losses in a year, those losses pass through to the owners and if the owners have other income, they can benefit from having the losses offset other income in the current year. There are some limitations so check with your accountant.

3. Contributions can generally be made by the members to the LLC at any time without tax consequences.

4. The LLC files an informational tax return but pays no income tax, instead items of gain, loss and other tax attributes are passed through to the members. With a single member LLC, there is no return at all and all tax reporting is done on the individual’s personal return.

5. Pass through taxation through an LLC also presents some opportunities for tax planning among members. This is an incredibly complex area and you should consult with your tax attorney or accountant, but one of the reasons the wealthy use LLCs so often is because of the tax flexibility offered.

Most limited liability companies are taxed as a pass through. So, I assume this question is based on an LLC that is not taxed as a corporation.

With pass through taxation, the LLC itself as an entity never pays taxes.  However, from an accounting perspective, all the accounting items that are relevant to the business are taken into account.

So, practically, you would take all your revenue, expenses, gains and losses for your business is and determine what the taxable income, if any, or the taxable loss of the business is at the end of the year.  You would apply all the tax rules, limitations, restrictions and benefits to these numbers.

The details of all the accounting items that are relevant to determining taxation are then set forth in a document which varies depending on whether your limited liability company is a single member LLC or a multi-member LLC.

For the single member LLC, the tax reporting and detail will be included in a Schedule to the single owner’s personal tax return.  The end number, if it results in taxable income, will be added to the single owner’s other income on his/her return for purposes of determining the overall tax liability.  If the business is actively run and there is a loss, then the single owner can take the losses to reduce his income tax liability on other income.

For the multi-owner LLC, the LLC includes the detail no an informational tax return – the Form 1065.  It then takes the bottom line income or loss and allocates it among the multi-owner members based on the provisions of the LLC Operating Agreement. Each member gets a form which shows his or her allocation of the LLC’s income or loss.

So, even though the LLC itself does not send a check to the IRS, the procedures and analysis for determining the taxable income or loss of the LLC business is done as a business entity.  But then the income or loss is passed through to the owners of the business to report on their individual returns.  The result of this is that the income of the business is only subject to one level of tax. And, in most cases, if there is a loss, a business owner can get a benefit by being able to take that loss to reduce tax liability on other income.

In 1997, the Internal Revenue Code passed regulations called the "Check the Box" rules which opened the floodgate for new limited liability company formations.  These rules took away very complicated and uncertain regulations for how a limited liability company would be taxed for federal income tax purposes and basically said, "Let each limited liability company decide for itself how it wants to be taxed."

LIMITED LIABILITY COMPANY CAN BE TAXED AS A CORPORATION IF IT DESIRES

Bfore 1997, one of the biggest reasons for choosing a corporation over a limited liability company WAS taxation.  Some businesses were better off being taxed as a C corporation or an S corporation under the IRS rules.  Well now- a limited liability company can choose to be taxed as a C corporation or an S corporation (assuming it meets the S corporation rules) for tax purposes and still get all the advantages of an LLC (limited liability company) under state LLC laws. 

This is the best of both worlds and,in essence, takes away most of the reasons why any small business would ever choose a corporation entity over an LLC entity.  There are no requirements for an LLC to meet if it desires C corporation taxation as long as it makes certain filings in a timely fashion.  If an LLC wants to be taxed as an S corporation, it must meet the same requirements that a corporation must meet to be eligible for S corporation taxation under the IRS laws.

Still today, in practice, many new businesses receive advice from their tax advisers that they should form a corporation instead of a limited liability company and then elect for the corporation to be an S corporation.  Accountants especially will recommend the corporation with the S corporation tax status because this is what they have worked under for years before the LLC was able to achieve this same tax status.  They are just used to the older way- but the older way may not be the best for you given the new options. This advice is usually given because the accountant or adviser is not up to date on the limited liability company as the better and more flexible choice.

A limited liability company imposes much less formalities on owners and provides a more flexible business entity for the small business.  Plus, the limited liability can elect to be taxed as an S corporation- so you get the best of both worlds.

I would definitely defer to your specific accountant or adviser in this decision as he or she should know a lot more about your business in order to arrive at the best advice for you.  However, if he or she advises to form a corporation for a small simple business, I would just make sure that he knows that a  limited liability company (LLC) can be taxed as an S corporation and find out another reason why he is advocating the corporation. 

DEFAULT TAXATION FOR A LIMITED LIABILITY COMPANY

Single Member LLC. If a limited liability company is a single member LLC, the default tax classification is that the IRS will be a "disregarded entity" for tax purposes.  This means that the single member will report all LLC business income on his or her own personal tax return.  It is the simplest method of taxation.  Remember, the entity is only disregarded for TAX purposes not other purposes such as limited liability and governance. 

If the single member LLC wants to be taxed as a C corporation or an S corporation (it must meet the S corporation requirements,) the single member LLC can do so by filing a certain election form with the Internal Revenue Service.  This election form must contain certain required information and must be filed within 75 days from the formation of the single member LLC in order to be taxed as a C or S corporation from its formation date.

Multi-Member LLC.  If a limited liability company has more than one member, the default tax classification is that the IRS taxes the LLC as a "partnership" under the IRS laws.  This is a single layer of taxation and the tax profits or losses flow through to each member and are eventually reported on their personal returns in a Schedule.  The LLC itself also has to file an informational return with the IRS. 

A multi-member LLC can choose to be taxes as a C corporation or an S corporation (it must meet the S corporation requirements) if it makes sense for the business.  Similar to above, an election form must be properly and timely filed with the IRS.

COMMON CHOICE FOR THE SMALL BUSINESS LIMITED LIABILITY COMPANY

The default tax classifications are what they are for a reason.  The great majority of small business limited liability companies prefer the single layer of taxation afforded by the disregarded entity taxation for a single member LLC or the partnership taxation for the multi-member LLC.  However, there are certain instances where corporation taxation may be more beneficial for your limited liability company especially in the area of employee benefits if you have or are planning on having a decent size employment staff or desiring to offer premium benefits to your employees (which may include yourself). 

Speak to your tax adviser for the best tax classification for your limited liability company.