The Advantages of an LLC Filing Federal Taxes as a Partnership Vs. S-Corporation

by Jane Meggitt

The Internal Revenue Service does not recognize the limited liability company as a tax classification. LLCs are set up under state statutes and must file federal taxes as either a corporation, partnership or S corporation. Depending on the nature of the LLC, filing as a partnership as an S corporation has certain advantages.

Limited Liability Companies

LLCs allow owners, officially known as members, to avoid personal liability for the business's actions or debts. In this sense, an LLC functions like a corporation. In other ways, it is similar to a partnership, because earnings are passed through to members for tax purposes, and income is filed on the individual's personal income tax return. While laws vary according to the state, members are not generally limited to individuals but also may include corporations and other LLCs. Many states permit LLCs with single ownership, a benefit over sole proprietorship, which holds the sole proprietor personally liable for business debts and legal actions. Certain businesses, including insurance companies and banks, are not permitted to operate as an LLC.

S Corporations

For federal tax purposes, S corporations may pass income, losses, credits and deductions to shareholders. These shareholders report income and losses on their personal income tax returns, similar to an LLC. Taxes are assessed and owed at the shareholder's indvidual tax rate. However, the S corporation must pay tax on passive income and gains. To qualify as an S corporation for tax purposes, the LLC must be a U.S. corporation and cannot exceed 100 shareholders. It must have only one stock class. While individuals and estates and some trusts may be shareholders in an S corporation, it cannot include corporations or partnerships.

Filing Taxes

If filing an LLC as a partnership, the members must file federal income returns paying self-employment tax for the individual's share of the partnership's earnings. If filing as an S corporation, LLC members do not have to file earnings as self-employment tax, but as shareholders in the S corporation.

Tax Advantages

Filing as a partnership with self-employment income allows certain tax deductions, such as business-related expenses, not available to the member whose LLC files as an S corporation. The LLC member filing under a partnership with self-employment income may also put up to 25 percent of annual earnings into a simplified employee pension individual retirement account, or SEP-IRA. As of the time of publication, the limit on the 25 percent SEP-IRA contribution is $49,000. The SEP-IRA may be set up even if you are covered by another employer-sponsored retirement plan, such as a 401k.

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