Income Tax Features of Partnerships and LLCs

The limited liability company (LLC) type of business entity borrows some income tax features from the partnership form and some features from the corporate form. The LLC is an unusual blending of features that have worked well for many business ventures.

A business organized as an LLC has the option to be a pass-through tax entity instead of paying income tax on its taxable income. A partnership doesn’t have an option; it’s a pass-through tax entity by virtue of being a partnership.

Following are the key income tax features of partnerships and LLCs:

  • A partnership is a pass-through tax entity, just like an S corporation. When two or more owners join together and invest money to start a business and don’t incorporate and don’t form an LLC, the tax law treats the business as a de facto partnership. Most partnerships are based on written agreements among the owners, but even without a formal, written agreement, a partnership exists in the eyes of the income tax law (and in the eyes of the law in general).

  • An LLC has the choice between being treated as a pass-through tax entity and being treated as a taxable entity (like a C corporation). All you need to do is check off a box in the business’s tax return to make the choice. Many businesses organize as LLCs because they want to be pass-through tax entities (although the flexible structure of the LLC is also a strong motive for choosing this type of legal organization).

The partners in a partnership and the shareholders of an LLC pick up their shares of the business’s taxable income in the same manner as the stockholders of an S corporation. They include their shares of the entity’s taxable income in their individual income tax returns for the year.

For example, suppose your share of the annual profit as a partner, or as one of the LLC’s shareholders, is $150,000. You include this amount in your personal income tax return.

Choosing the best legal structure for a business is a complicated affair that goes beyond just the income tax factor. You need to consider many other factors, such as the number of equity investors who will be active managers in the business, state laws regarding business legal entities, ease of transferring ownership shares, and so on. After you select a particular legal structure, changing it later is not easy. Ask the advice of a qualified professional to prevent costly mistakes.

Business owners have to make compromises and balance the advantages and disadvantages when choosing a legal structure for their business. In its external financial reports, a business has to make clear which type of legal entity it is. The type of entity is a very important factor to the lenders and other creditors of the business, and to its owners of course.

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