Entity Selection Series - Part 1, Limited Liability Companies

You have seen the hype on social media....

Form an LLC and save thousands in taxes....

One of the very first things that I do when I walk someone through the entity selection process is outline the pros and cons of form an LLC, both from a legal standpoint and also from a tax standpoint.

Even so, most people think forming an LLC automatically determines how your business is taxed.

As we will discuss, in reality, LLC's are creatures of State law, they are legal structures not a tax classification.  Understanding the various ways that an LLC can be taxed will help unleash the power of this flexible entity structure.

Let's explore it together:

Pros and Cons, the Legal Analysis

Limited Liabiltiy Companies or LLCs are hyrbid legal entities that started to crop up as early as the 1970's. However they ultimately gained a significant amount of popularity after 1997 with the right of the "Check the Box" rules, which allowed advisors and business owners to easily decide how that entity would be taxed (something I'll discuss below).

At its core, the reason why so many business owners favor LLC's compared to other types of legal entities is their simplicity, both in design, administration and management.

LLC's are governed under state law, which each state imposing slightly different requirements on the operations of the company.  

Simplicity

LLC's at their core are simple. 

The entity can be owned by just about anyone, U.S. persons, Foreign Persons, Trusts, Corporations, other LLCs and more. So while different rules of construction and different tax laws might be applicable, there is almost no restriction on who can own the entity.

Moreover, the operations of the entity are also simple depending on the number of different owners that the entity has. Typically, however, it is simply majority or unanimous voting, unless the owners agree differently. 

Flexibility

The other benefit of LLCs is in their flexibility. Given the relatively broad rules surrounding their formation, there is nearly limitless ways that the business dynamic between owners can be structured.

Frequently we will see variations in ownership rights, voting rights, as well as other items such the ability to leave the business or whether minority owners are forced to sell if a majority member receives an offer to buy the business (something know as drag-along rights)

Administration

Another consideration when it comes to LLCs is their easy administration. 

Usually there are no formal requirements for meetings of the owners or the management of the company, unlike corporations. There are also very loose requirements are requiring written resolutions, minute books, etc. That said, it is always important for the organization to document everything regardless to avoid disputes.

Downsides

While LLCs can be great tools in many respects, they aren't without their own issues.

In the SMB world, the most significant downside to LLCs is both the risks surrounding making an S Corporation election and theri default ineligibility for QSBS (which will be a topic of discussion for a different newsletter).

The default ineligibilty for QSBS may also serve as a sticking point for investors looking for an acquisition opportunity with a tax free exit. 

Taxation of LLCs

Overall, LLCs provide such immense flexibility in their structure that the typically make sense for the vast majority of new and small business owners looking for legal protection and simple managment. 

That said, LLCs also provide a ton of flexibility through something called the "Check the Box" rules. 

In the late 1990s, the IRS confronted widespread confusion over how LLCs should be classified for federal tax purposes. Prior to 1997, entity classification required a complex, multi-factor “Kintner test,” forcing taxpayers to analyze characteristics like continuity of life, centralized management, and free transferability of interests. Because LLC statutes were rapidly evolving and often blended features of partnerships and corporations, determining the correct tax classification became unpredictable and burdensome. To resolve this, Treasury issued the “check-the-box” regulations in 1997, which replaced the old tests with a straightforward, elective system: most unincorporated business entities could simply choose whether to be taxed as a partnership, C corporation, or an S corporation.

With this backdrop, let's explore the different ways an LLC can be taxed:

Default Taxation: Disregarded Entity or Partnership

All LLCs break down into two simple categories: LLCs owned by a single-person or LLCs owned by 2 or more people. 

As with all things in law and taxes, the IRS has outlined what the default rules are before 

• Single-Member LLC (SMLLC):

  • Default: Disregarded entity—income and expenses reported directly on the owner’s personal tax return (Schedule C, E, or F).

  • Effectively treated like a sole proprietorship for tax purposes.

• Multi-Member LLC:

  • Default: Partnership taxation—files Form 1065 and issues K-1s to each member.

  • Profits and losses “pass through” to members based on ownership percentages or operating agreement terms.

Key point: These default classifications avoid corporate double taxation but may expose owners to self-employment tax on earnings.

S Corporation

• How it works: LLC files Form 2553 to elect S Corp status.

• Benefits:

  • Allows owners to split income into “reasonable salary” (subject to payroll taxes) and “distributions” (not subject to self-employment tax).

  • Potentially significant savings on Social Security and Medicare taxes.

• Considerations:

  • Must pay reasonable compensation to owners actively working in the business.

  • Stricter rules on number/type of shareholders (e.g., no foreign members, only one class of stock).

  • Additional payroll and compliance requirements.

C Corporation

• How it works: LLC elects to be taxed as a C Corp by filing Form 8832.

• Benefits:

  • Flat 21% corporate income tax rate.

  • Ability to retain earnings in the company without immediate tax to owners.

  • Potential access to Qualified Small Business Stock (QSBS) under §1202, which can result massive tax savings at exit.

• Drawbacks:

  • Double taxation: profits taxed at corporate level, then dividends taxed again when distributed.

  • More complex compliance.

What Should You Do?

Once you understand the flexibility of LLCs, you can begin to sort through your options, its similar to a buffet. Do you want a single-member LLC or a multi-member LLC? Do you want it to be taxed as a partnership, C Corporation or S Corporation? 

Ultimately the answer depends on you and your particular situation. As a good rule of thumb, keeping decisions simple early on and then adding in layers of complexity will always be a winning strategy compared to making complex moves early on and then needing to unwind such a structure after the fact.

Up on Deck: Corporations

As you can see, the LLC is the most flexible entity structure in U.S. business law because it allows you to select the tax regime that aligns with your goals. But flexibility comes with complexity. The “right” choice depends on your revenue, compensation needs, investor profile, and long-term exit plans.

Next week we will explore the advantages and disadvantages of C Corporations and how they differ from you vanilla LLC.