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To understand the exception, we need to step back in time.
To the surprise of many, the limited liability company is a relatively new form of business. It was created out of the blue by Wyoming in 1979. While the politicians indicated they were trying to be business friendly, they were really trying to find a way to generate more tax revenues. What better way than to create a new, flexible entity that was perfect for small businesses? Well, there is little disputing they stumbled onto something, but there was one hitch.
From 1979 to the late 80s, the LLC more or less went unnoticed. Why? The IRS took a long time in figuring out how it would be taxed. Would it be taxed like a corporation or like a partnership? Should an entire new section of tax code be created for it? The IRS never really came up with a good answer, so they let people select if they wanted to be taxed as a corp or partnership. Most picked partnership and everything was fine.
States are jealous of each other. When the IRS finally figured out how it would tax the limited liability company, all the other states immediately started passing laws that allowed LLCs to be formed in their states. A majority of the laws even allowed one person to form the entity. This caused immediate problems when most of these single owner LLCs filed partnership tax returns.
A partnership is a business venture between two or more people. This is a basic legal axiom that has been around forever. It is also imbedded in the tax code. You can probably guess the problem. How could a single owner LLC file taxes as a partnership. There is only one person!
After some debate, the IRS made its decision. A single owner LLC is to be treated like a sole proprietorship for tax purposes. You are probably wondering why you should care? Well, the ruling means that you have to pay the 15.2 percent self-employment tax if you are the proud owner of a single owner LLC. Most people don’t know this when they decide to form the entity and they get a very nasty surprise when it is time to pay Uncle Sam.
If you want to form a single owner LLC, there is nothing wrong with that. Just make sure you understand self-employment tax will be due and you have the money to pay it.
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While LLC owners enjoy limited personal liability for their business transactions, this protection is not absolute. This drawback is not unique to LLC’s, (however the same exceptions apply to corporations). An LLC owner can actually be held personally liable if he :
1) personally guarantees a bank loan or a business debt on which the LLC defaults
2) fails to deposit taxes withheld from employees' wages
3) intentionally does something fraudulent, illegal, or reckless that causes harm to the company or to someone else, or
4) treats the LLC as an extension of his or her personal affairs, rather than as a separate legal entity.
NB for Kurt: In the Missouri, you can actually file as an S-Corp. even though you’re an LLC..
Raphael S. Barchichat LL.B., LL.M.c.l., LL.M. Taxation
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