You're starting a new business. Your friend told you to set up a limited liability company (LLC). So you set one up and opened up a bank account. You're ready to dive in. But you forgot one thing--how is the LLC taxed? It seems your friend forgot to mention this part.

Understanding LLC taxation can be tricky. Get it right and your business is off to a great start. Get it wrong and you could be looking at filing penalties, interest and a stream of letters from the IRS.

How LLCs Are Taxed

If you are a new business owner, chances are good that you don't have a thorough understanding of how LLC taxation works. LLCs are incredibly flexible ownership structures. They have default tax classifications, but allow the owners to elect to be classified differently.

A single-member LLC starts off being treated by the IRS as a "disregarded entity." If the member is an individual, then the income and expenses are included on his or her personal return. If the member is another entity, the activity is then included on the return of the member entity. In either case, the LLC does not file a separate tax return.

If the LLC has more than one member it is treated, by default, as a partnership and files Form 1065. Partnerships are subject to "flow-through" taxation, which means they don't pay any tax. Each owner receives a Form K1 from the partnership and will be taxed on his or her share of the profits or losses.

LLC S Corp vs LLC C Corp

When people talk about business taxes, they often throw around terms like "S corporations" and "C corporations." Similar to a partnership, an S corporation has flow-through taxation. On the other hand, a C corporation results in the company itself paying taxes before profits are distributed to owners as dividends.

Understanding how corporations are taxed is imperative before you set up your LLC. Why? Because an LLC has the ability to choose how it is ultimately taxed. Even though LLCs are subject to default classifications, they allow the members flexibility to elect to be taxed as corporations.

In fact, many LLC members want to be taxed as S corporations. This can be accomplished by timely filing Form 2553. Is your plan to be a C corporation? No problem -- just timely file Form 8832. While there are some limitations and exceptions, these elections can be made by single-member and multi-member LLCs. It is important to note, these elections do not change the legal structure. It is still an LLC for legal purposes, but being taxed as a corporation.

IRS Penalties for LLCs

Late filing penalties for S corporations and partnerships can be brutal. They are $195 per month (or part thereof) multiplied by the number of shareholders or partners. Fortunately, they are capped at 12 months, but they can add up quickly.

Let's look at a few client situations where sizable headaches and penalties were incurred:

  • An LLC was set-up with 13 members. They did not understand the filing requirements. The tax return was filed 6 months late with penalties in excess of $15,000. Not fun.
  • The member of an LLC wanted to file as an S corporation, but actually filed an election to be a C corporation. This resulted in double taxation -- taxation at the corporate level and then again as a dividend to him personally.
  • On numerous occasions, clients have made payroll errors as a result of not understanding their entity structure. This includes no payroll being issued to members electing S corporation status (reasonable compensation is required) and payroll issued to single-member LLC owners (not required).   

LLCs are great entity structures. But be careful. Don't set up your LLC until you understand the tax consequences and your options. Ask plenty of questions up front so you can avoid problems down the road. You are better off safe than sorry.