Limited Liability Company (LLC)

A limited liability company is an unincorporated business entity formed by filing articles of organization with a state, whose members are generally not personally liable for the company's debts and obligations. The IRS opens its own explanation the same way, describing an LLC as "a business structure allowed by state statute" and directing readers to check with their state. That framing is the key to everything else on this page. The LLC is a legal form, not a tax status. Federal tax law has no category called "LLC," so after a business is organized as one, a second question has to be answered separately about how it will be taxed.

The confusion this page exists to clear up is the "LLC versus S corporation" question, which is not a real choice between two alternatives. An LLC is a state-law entity. An S corporation is a federal tax classification. An LLC that elects S corporation treatment is still an LLC in every respect that state law cares about, including how it is governed, what it must file with the state, and how its liability shield works. The two answer different questions and can both be true of the same business.

There is a trap in reading the IRS's own summary of this. Its Classifications section names three destinations, corporation, partnership, or disregarded entity, and mentions only Form 8832. Read as a closed list, that tells a reader the S corporation route does not exist for an LLC, and it does. Under 26 CFR 301.7701-3(c)(1)(v)(C), an eligible entity that timely elects S corporation status under IRC 1362(a)(1) "is treated as having made an election under this section to be classified as an association," provided it meets the small business corporation requirements. In practice that means an LLC electing S status files Form 2553 alone and does not need to file Form 8832 first. An IRS overview page enumerates the common cases and is not exhaustive; the form instructions and the regulation are where the complete answer lives.

"Limited liability" is limited, and the boundaries matter more to a small business owner than the shield does. State law does not protect an owner from liability for their own negligent or wrongful acts. It does not protect them from a debt they personally guaranteed, which covers most small-business bank loans, many commercial leases, and a surprising number of vendor accounts. And it does not protect them from unpaid trust-fund payroll taxes, because IRC 6672 imposes a penalty equal to the unpaid amount on any responsible person who willfully fails to collect or pay it over. An owner who forms an LLC and then guarantees the lease and signs the loan has changed less than they think.

Formation is a state process. The owner files articles of organization, pays a filing fee, usually names a registered agent, and in many states pays an annual report fee or a franchise tax to keep the entity in good standing. Fees, annual obligations and the details of the liability shield vary enormously from state to state, and none of it is federal.

Federal tax classification is then decided separately, by default rules with an election available:

• One member, no election. The LLC is a disregarded entity. Its activity is reported on the owner's own return, typically on Schedule C, and the owner pays self-employment tax on the net earnings exactly as a sole proprietor would.
• Two or more members, no election. The LLC is treated as a partnership, files Form 1065, and issues a Schedule K-1 to each member.
• Any number of members, Form 8832 filed. The LLC is treated as a C corporation and files Form 1120.
• Eligible LLC, Form 2553 filed. The LLC is treated as an S corporation, files Form 1120-S, and its owner-employees must be paid a wage through payroll.

Election timing is a real deadline. A Form 8832 election cannot take effect more than 75 days before the date it is filed, nor more than 12 months after it. Late-election relief exists but has to be requested.

A hypothetical, resolving what changes rather than an amount. Marcus runs a landscaping business as a sole proprietor with two employees, and forms a single-member LLC in April. Three things happen and one does not. His personal assets gain a state-law shield against business creditors, subject to the holes above. He now has an annual state filing to keep up. And his LLC must use its own name and employer identification number for the employment tax returns covering his two employees, because under IRS guidance an LLC with one member "is still considered a separate entity" for employment and certain excise taxes. What does not change is his income tax. The business is disregarded, the profit lands on his Schedule C at the same rates, and he owes the same self-employment tax he owed in March. "Taxed exactly as you already were" is the right answer to the rate question and the wrong answer to the payroll question.

Pros

• A state-law liability shield that a sole proprietorship does not have, for a modest filing fee.
• Flexible tax treatment. The same entity can be taxed four different ways, and the choice can change as the business grows.
• Far less formality than a corporation in most states. No required board, no stock, and usually no minutes.
• No restriction on who or what may be a member, unlike an S corporation.
• Credibility with customers, landlords and banks, which is a real if unglamorous benefit.

Cons

• The shield does not reach the owner's own acts, personally guaranteed debts, or unpaid trust-fund payroll taxes, which together cover most of what actually goes wrong.
• Ongoing state cost and paperwork, and both vary widely by state.
• Forming one does not by itself reduce any tax, and a business owner who expected it to will be disappointed.
• Mixing personal and business funds in the same account undermines the shield the entity was formed to create.
• A multi-member LLC needs an operating agreement to work properly, and the state default rules that apply without one rarely match what the owners intended.