The LLC is a state recognized legal entity for conducting business. It works as well for the small individual business owner who is simply seeking to limit legal liability as for a larger business with many owners. The LLC also facilitates changes in its tax classification.
The following example demonstrates the utility and flexibility of an LLC. A small business owner registers his business as an LLC to obtain the protection of limited legal liability. Initially the business is too small to take on the expense of filing its own separate return so the business owner elects to be taxed as a sole proprietor. The business owner needs to file no forms to make this election as the default tax classification for a single member LLC is a sole proprietor. This classification allows the business owner to report the transactions for his business on schedule C which is filed along with his form 1040.
If the number of owners increases to more than 1, the tax classification changes to a partnership, which has to file form 1065 annually along with K1s for each owner. The K1 reports the share of profit or loss attributable to each owner, and this amount is included on the individual’s 1040.
At some point the owners may wish to take advantage of the S corporation classification. In order for the LLC to be classified as an S corporation, 2 forms need to be filed: first file form 8832 to classify the LLC as a corporation, and then file form 2553 to make it an S corporation. Businesses that wish to be classified as C corporations would file only form 8832. Once these forms are filed with the IRS, expect IRS letters agreeing to classifications requested in both forms. Businesses should keep these letters as part of their permanent records, in case the IRS disputes the tax classification.
The ability to change the tax classification of the LLC allows businesses to reorganize without having to liquidate an existing entity. It is important to remember that changes in tax classification are only allowed once every 5 years.