Limited liability companies are treated as partnerships for income tax purposes. The LLC does have the option to be taxed as a corporation. If they wish to do this, they need to file Form 8832, Entity Classification Election. If an LLC only has one member, they are treated as a sole proprietor for income tax purposes. The sole member would report the LLC income and deductions on Schedule C of their Form 1040.
Since the LLC is normally treated as a partnership, they are required to file Form 1065, U.S. Return of Partnership Income. Because the LLC is a pass-through entity, with Form 1065, each member of the LLC will receive a Schedule K-1, showing their share of the LLC income or loss. The member then uses the Schedule K-1 to report this income or loss on their personal Form 1040. The income would be shown on Schedule E, in Part Two, Income or Loss from Partnerships and S Corporations.
When the LLC experiences a net loss for the taxable year, the amount of loss that can be claimed by each member has certain limits. Each member can only claim the loss up to the amount of their basis in the LLC. Their basis in the LLC is the amount of cash and/or property they have contributed to the LLC. Also, in the case of a member that does not actively participate in the operation of the business, the passive loss limitations would apply.
In some cases, the limited liability benefit of the LLC will not be available to the members of the LLC. For instance, if one or more of the members personally guaranteed a loan to the LLC, those members would retain personal liability for that loan. Another situation that would void the limited liability protection is if the LLC did not withhold and deposit payroll taxes, such as employee income tax withholding and FICA tax withheld from employees.
A special form of LLC is the limited liability partnership, or LLP. These are basically LLCs for attorneys, accountants, doctors, and other professionals. These are established easily by filing the necessary paperwork with the appropriate state. For both LLCs and LLPs, it is crucial that the members draw up either an LLC or LLP agreement, outlining the purpose of the organization, capital accounts, allocation of profits and losses, duties of members, terms related to dissolution, transfers of memberships, etc.
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