There’s an old accountant joke (yes, there are jokes about accountants—you just don’t usually hear them because only accountants tell them) about a client interviewing a series of firms to determine which one will get his business. He asks each accountant to solve a very simple mathematical equation: “How much is 2 plus 2?” Each accountant comes back with the right answer, mathematically, and he sends each away. Finally, the accountant who gets his business answers his question with the question “What do you want it to be?”
Obviously, as accountants, when it comes to counting dollars and computing taxes, we could not legally (not to mention ethically) be as “flexible” as the fellow who got the work in the joke. However, in today’s business environment, there is a parallel business question that accountants can (and should) answer with the question “What do you want it to be?” and that is the question, “How are Limited Liability Companies (LLC’s) taxed?” Over the last twenty 20 years or so, LLC’s have become the “go-to” entity type when lawyers are asked by clients as to which business form to choose. Legally, they generally offer the same type of owner liability protection as a corporation under state law. When LLC’s first started being used, the IRS recognized that these unique business forms had some of the characteristics of a corporation and some of the characteristics of a partnership, and there was a list of characteristics used to see if the LLC had more corporate or more partnership characteristics, and that would determine how the LLC was going to be taxed. This method of determining such a basic thing as entity taxation was, at best, cumbersome for both taxpayers and the IRS, and frequently landed the two in court.
Now, the last place the IRS, and most taxpayers, wanted to be was in court arguing about the most basic question: “How is this entity going to be taxed?”? So, the IRS, in a revolutionary move, issued the “Check the Box Regulations” and Form 8832. Basically, in doing so, the IRS said to taxpayers “We are not going to fight over this with any more.- yYou choose how you will be taxed by “checking a box” on Form 8832. -aAbsent your choice, we will choose for you based on a very definite and simple default rule.”
The simple default rule is this: “If a domestic LLC has one owner (member), it will not be recognized as an entity separate from its owner, but will be a disregarded entity for TAX purposes;. iIf it has more than one owner, it will be taxed as a partnership.” That means that if a single corporation owns the LLC, it will be taxed as merely a division of the corporation owner. If one individual owns the LLC, it will be taxed as a “sole proprietorship” and reported on Schedule C of Form 1040 of the owner. If two or more owners own the LLC, the LLC will be taxed as a partnership (a partnership is generally not taxed as an entity-, its earnings or losses flow through to its owners’ tax returns).
However, if the owners do not want to be taxed under the default rule, they have the option of filing a Form 8832 to elect that their (single- or multi-member) be taxed as a separate corporation, or even (by filing a Form 2553) to elect that their LLC be taxed as an S Corporation.
Choice of entity type is often one of the first (and most important) decisions a business owner faces when forming a new business. It is also a choice that sometimes needs to be revisited and re-decided at various points in a business entity’s life cycle. It is important for a business owner (and his or her advisors) to realize that an LLC can be classified for tax purposes in different ways, while still retaining its legal status under state law. Be sure to consult with both your attorneys and your accountants when making this important decision.