Is an LLC a Pass Through Entity: Everything You Need to Know
Is an LLC a pass-through entity? Answering this question requires that you understand some basic information about limited liability companies (LLCs) and how they differ from other business entity types.3 min read
2. LLC Basics
Is an LLC a pass-through entity? Answering this question requires that you understand some basic information about limited liability companies (LLCs) and how they differ from other business entity types.
Business Structure Types
There are several business structures that can choose for your company. When it comes to simple formation, the most popular business entity is a sole proprietorship. With a sole proprietorship, you would report all expenses and business income on the 1040, Schedule C form instead of filing a separate tax return.
Another type of business entity is a partnership, which is formed when one two or more people decide to form a business. There are different types of partnerships available, including limited and general partnerships. Separate returns are filed for the partners within a partnership, and all losses and income are passed to the partners. The partners are then required to report the income and losses on their tax returns.
If your business is an LLC, you can choose to be taxed either as a corporation or a partnership. Many people choose to form Single Member LLCs, which are limited liability companies with one owner. In terms of taxes, a Single Member LLC will be treated similarly to a sole proprietorship. They will report income and expenses on the Schedule C form.
When most people think of a business, they are thinking of something called a C Corporation. To pay taxes, C Corporations file an 1120 federal form. Shareholders of the C Corporation will be taxed at the individual rate for any dividends or other income they receive from the business. This practice is often referred to as double taxation.
People in certain positions may choose to form a Personal or Professional Service Corporation instead. This type of business entity is a popular choice for licensed professionals, such as:
S Corporations are similar to partnerships in terms of taxes. When an S Corporation files an 1120-S form, income and losses are passed to shareholders who then must report this financial information on their personal returns.
Like a corporation's shareholders, an LLC's members are not personally liable for debts or claims against the company. This means that when a company is unable to pay a debt, the personal property of the LLC members, such as homes and cars, are shielded from the creditor. The protection of personal property is the main reason that LLCs are the most popular business entity among entrepreneurs.
The assets of LLC owners will be used to cover debts of the business, which mean members of the LLC can only lose the money that they originally invested in the company. Although members of an LLC do have limited liability when it comes to their personal assets, there are certain exceptions to these protections.
Circumstances where the owner of an LLC will still be held personally liable include:
- Personally injuring another person
- Personally guaranteeing a debt or loan for the business that the company then defaults on
- Neglecting to deposit withheld taxes that have been collected from the LLC's employees
- Engaging in illegal or fraudulent practices that incur damages against the LLC or another person
- Failing to separate personal and business finances
Mixing business and personal assets is the most common reason that LLC members are held personally liable for business debts. When the members of an LLC do not treat the company as if it were separate from their personal assets, the court may conclude that the LLC doesn't exist, meaning that all business being performed by the company is actually the personal business of the company owners.
Follow these tips to keep your LLC viable and to maintain your personal liability protections:
- Never attempt to mislead creditors or vendors about the finances of your LLC.
- Make sure that your LLC is properly funded and that you're investing enough capital to cover your expenses.
- Always separate your personal and business finances by opening a bank account solely for company use, obtaining an Employer Identification Number (EIN), and using the accounting books for your LLC only for company business.
- Develop a formal operating agreement that establishes the rules of your company so that you appear credible.
While it can be more time-consuming to establish an LLC than other types of business entity, operating a limited liability company is fairly straightforward.
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