Multi-member LLCs are popular because they combine the best legal and tax characteristics of corporations and partnerships. Specifically, a multi-member LLC can offer limited liability protection to all its owners (referred to as “members”) while being treated as a partnership for federal tax purposes.
Liability protection. When you operate as an LLC, state law generally protects your personal assets from exposure to business-related liabilities. Such exposure can include everything from a lawsuit filed by the FedEx guy who slips on ice-covered steps to the seemingly endless variety of liabilities that can be caused by the actions or inactions of employees.
Key point. Unfortunately, no type of entity (including an LLC) protects your personal assets from exposure to liabilities related to your own professional malpractice or your own tortious acts.
Pass-through taxation. Multi-member LLCs are treated as partnerships for federal income tax purposes—unless you elect to have the LLC treated as a corporation.
When you are in a partnership, your share of the business’s taxable income items, deductions, and credits is passed through to your personal return. You pay taxes at the personal level on your share of the LLC’s profits. Generally, you have no entity-level federal income tax, so you don’t have to worry about the double taxation issue that can potentially haunt C corporations.
Fewer tax-free fringes for owners. Compared with C corporations, multi-member LLCs that are treated as partnerships for tax purposes cannot provide as many tax-free fringe benefits to owners. The fringe benefit rules for multi-member LLCs are essentially the same as the rules for S corporations.
More exposure to self-employment tax. You may owe self-employment taxes—consisting of the Social Security tax component and the Medicare tax component—on income passed through to you by the LLC. In contrast, if you run your business as a corporation, Social Security and Medicare taxes apply only to amounts paid as salary to you and the other owners.
Key point. Under some state laws and/or applicable professional standards (such as state bar association rules), LLCs may be prohibited from operating certain types of professional practices. But when permitted, LLCs are a good choice.
Differences between Partnership and S Corporation Tax Rules
While both partnerships and S corporations benefit from pass-through taxation (where taxable income items, deductions, and credits are passed through to the owners and reported on their personal returns), there are some significant differences between the partnership tax rules and the S corporation tax rules. Most of these differences are in favor of partnerships. They include the following:
- Partners can receive additional tax basis for loss deduction purposes from entity-level liabilities, whereas S corporation shareholders can receive additional tax basis only from loans made by them to the corporation.
- A partner who purchases a partnership interest from another partner can step up the tax basis of his or her share of partnership assets, which minimizes taxes for the purchasing partner when the partnership sells assets or converts them to cash.
- Partners and partnerships have much greater flexibility to make tax-free transfers of assets (including cash) between themselves than do S corporations and their shareholders.
- Partnerships can make disproportionate allocations of income, tax losses, and other tax items among the partners. In contrast, all S corporation pass-through items must be allocated among the shareholders strictly in proportion to stock ownership.
Most advisors agree that the multi-member LLC is the best entity alternative for businesses with several owners if pass-through taxation is desired (such as with a service business where there is no need to retain significant amounts of earnings within the business entity).