Is an LLC a corporation or a partnership? Incorporating a business is a more formal process beyond what is required to form an LLC. It's important to select the right business entity structure. Each business is different and has unique needs for asset protection and preferred tax status. There isn't one single type of business structure that fits all scenarios.

What is an LLC?

Owners of LLCs are called members. The IRS does not recognize an LLC as an entity. Therefore, LLC members need to determine how they want to be taxed — options include sole proprietorship, partnership, or corporation. If not specified, the IRS considers an LLC a partnership by default, which is a "pass-through" tax entity.

If you have a multiple-member LLC, it will be taxed as a partnership with each member reporting profits and losses on their own tax returns. It can elect, though, to be taxed as a corporation instead. With pass-through taxes, the LLC doesn't pay any taxes at the company level. Single-member LLCs cannot be a partnership, they must opt for sole proprietorship status.

LLCs have some flexibility and are not required to keep a formal management structure per se. You can opt for member-managed (where all members have equal say) or manager-managed where one or more people are appointed to make decisions.

LLCs are designed to offer some liability protection to the owners, which is why they have "limited liability" in their designation. As long as members maintain a strict separation between personal and business assets, there is little to no risk of personal assets being attached to satisfy LLC liabilities and obligations.

There are some circumstances that can open members up to personal liability. These include:

  • Mismanaging business affairs
  • Engaging in illegal or fraudulent activities
  • Personally guaranteeing a business-related loan
  • Failing to maintain separation between personal and business assets

One issue with LLCs is the risk of termination if an owner wants out or passes away. This is dependent on the laws of the state where the LLC is based. States have similar laws for LLCs, but there are some differences which can cause a business to be a corporation in one state and an LLC in another.

Partnerships

To be a partnership, a business must be owned by two or more people and be "for profit." There are minimal upfront costs and they are easy to form. Personal liability is one of the biggest drawbacks to forming a partnership, however. Especially because members are liable for actions of other partners.

For pass-through tax status on a partnership, it still needs to file IRS Form 1065, but there are no taxes due. Form 1065 is primarily informational to verify that amounts reported on Schedule K-1s are accurate. These are sent to partners and show the partner's respective share of profits and losses they must claim on their own taxes.

Corporations

For businesses who foresee offering stock down the line, a corporation is probably the better option right from the start. C corporations, which are traditional corporations, are separate legal entities and offer liability protection to shareholders. The downside is the double-taxation issue, which means the corporation pays taxes on the income and then shareholders pay taxes on distributed dividends.

Another type of corporation is the relatively new S corporation. It is treated as a pass-through entity as well, but also eliminating the double-taxation issue with regular corporations. Not all businesses will qualify for S corporation status so it's important to understand the requirements. For example, if you want to have more than 100 shareholders, offer different classes of stock, or have shareholders who are international or other business entities, then you wouldn't qualify for S corporation status.

Differences Between Partnerships, LLCs, and Corporations

Choosing a partnership, LLC, or corporation can make a huge difference in how your personal assets are affected and what your tax burden is. Some differences to keep in mind:

  • The LLC is a relatively new business structure and it combines the benefits of a partnership and a corporation.
  • It's important to distinguish what sets LLCs, partnerships, and corporations apart, and understand what a legal entity is versus a tax entity classification.
    • Tax entity classification refers to how the IRS views a business for tax purposes.
    • A legal entity is one who can enter contracts, sue, be sued, etc.
  • A corporation is a legal entity and it's given either C corporation or S corporation designation for the IRS as the tax entity status.

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