1.3 Limited Liability Companies (LLCs)
SLO 1
Describe the legal and administrative steps required to start a small business (business name registration, EIN, licenses/permits, business bank account), implement a basic recordkeeping system, and compare sole proprietorships, partnerships, LLCs, S-corporations, and C-corporations in terms of liability exposure, tax treatment, and formation/compliance requirements in order to recommend an appropriate entity structure for a given business scenario.
The LLC is where this outcome's comparison stops being a simple ranking. In the sole proprietorship and the partnership, liability and taxation came bundled together; here you see the two come apart — state law grants every LLC the same liability shield, while federal law lets the same business choose to be taxed as a disregarded entity, a partnership, a C corporation, or an S corporation. You work through what California actually requires to form one (Articles of Organization, the Statement of Information, and a minimum annual franchise tax owed whether or not the business profits), what the shield does and does not cover (nothing against your own negligence, nothing you signed a personal guarantee for, and nothing once a court pierces the corporate veil), and which default classification follows from having one member versus several. That combination is exactly what the outcome asks you to weigh: when you recommend a structure for a business scenario, the LLC is usually the form you are arguing for or against, and this section gives you the formation costs, the liability limits, and the tax options to make that argument concretely.
Learning Objectives
By the end of this section, you will be able to:
- describe the California formation requirements and the annual franchise tax that apply to an LLC;
- explain the limited liability protection an LLC gives its members and how it compares with a sole proprietorship or partnership;
- explain how an LLC's flexible tax classification works — default and elected — and how each option is taxed.
A Limited Liability Company (LLC) is a relatively new business structure, created by state statute, that has become the default choice for many small businesses precisely because it combines the best features of the forms you have already met. Like a corporation, its owners have limited personal liability for the debts and actions of the business. Like a partnership, it offers management flexibility and pass-through taxation. In other words, the LLC tries to give you the liability shield of a corporation without the corporation's double taxation and heavy formality — which is exactly why it is so popular with small business owners.
A limited liability company (LLC) is a business structure created by state statute in which the owners — called members — have limited personal liability for the debts and actions of the business, while the business itself retains management flexibility and, by default, pass-through taxation.
The LLC inherits the corporation's armor and the partnership's light touch. It gets the shield that keeps creditors away from your house, and the single layer of tax that keeps the IRS from billing the same dollar twice. That combination is the whole reason the form exists.
The owners of an LLC are called members. Because most states do not restrict ownership, members may be individuals, corporations, other LLCs, or foreign entities, and there is no maximum number of members. Most states, including California, also allow single-member LLCs with just one owner. A few kinds of business — notably banks and insurance companies — generally cannot organize as LLCs.
Weighing the LLC form. The LLC's advantages are real, but so is its price tag — and the trade-off is what decides whether it fits a particular business:
| Advantages | Disadvantages |
|---|---|
| Limited personal liability. Members' personal assets are shielded from the business's debts, the way a corporation's shareholders are (developed in §1.3.2). | An annual franchise tax. California charges every LLC a minimum yearly tax whether or not it earns a profit — a cost a sole proprietor never pays. |
| Flexible tax classification. Federal law lets the LLC be taxed as a partnership, a corporation, an S corporation, or a disregarded entity (developed in §1.3.3). | Formation is not automatic. Unlike a sole proprietorship or a general partnership, an LLC exists only after articles of organization are filed and fees are paid. |
| Management flexibility. No board of directors and no mandatory corporate formalities; the members write their own operating rules. | Ongoing filings to stay in good standing. Statements of Information and franchise-tax payments must keep being made, or the entity — and its shield — can lapse. |
| No ownership restrictions. Any number of members, of nearly any type, including a single owner. | The shield can be lost. Commingling funds or ignoring the entity can let a court reach members personally anyway (developed in §1.3.2). |
What makes the LLC genuinely distinctive is that its two most important features are decided separately. State law gives every LLC the same liability shield (§1.3.2), while federal tax law lets the LLC choose how it is taxed (§1.3.3). A sole proprietorship is stuck with unlimited liability and pass-through tax; a C corporation is stuck with limited liability and double taxation. The LLC lets an owner mix and match: limited liability plus the tax treatment that fits the business. The three subsections below cover forming an LLC in California, the liability protection members receive, and that signature tax-election flexibility.
Definition 1.3.1 — The LLC inherits the corporation's liability shield and the partnership's flexibility and pass-through taxation.
1.3.1 California formation requirements and franchise tax
Unlike a sole proprietorship, an LLC does not come into existence automatically. It is a creature of state law and must be formally created by filing articles of organization with the state. That filing is what brings the entity into being and what erects the liability wall between the business and its members — which is why forming the LLC correctly, and keeping it in good standing, is essential to the protection it provides.
Articles of organization are the formation document filed with the state to create an LLC. Filing them is what brings the entity legally into existence and establishes the separation between the business and its members' personal affairs.
In broad terms, forming and maintaining a California LLC involves:
- choosing an available business name that complies with California's naming rules and includes an LLC designator;
- filing Articles of Organization with the California Secretary of State and paying the filing fee;
- filing an initial Statement of Information shortly after formation, and periodically thereafter;
- adopting an operating agreement (see below); and
- paying the state's annual franchise tax for the privilege of doing business in California.
Most business costs scale with the business — no sales, no sales tax. The franchise tax does not. California charges it for the privilege of operating as an LLC, so a business that lost money all year still owes it. For a very small venture, that fixed cost can outweigh the shield it buys.
The California franchise tax — a real, recurring cost. This is the item that most often surprises new LLC owners and that the sole proprietorship and general partnership largely avoid: California imposes a minimum annual franchise tax on every LLC doing business in the state, owed to the Franchise Tax Board (FTB) whether or not the business earns a profit. Higher-revenue LLCs owe an additional fee based on gross receipts. In other words, the LLC's liability protection and tax flexibility come at the price of a guaranteed yearly cost that a sole proprietor does not pay — a trade-off a very small or marginally profitable business should weigh carefully.
The operating agreement. Members should adopt an operating agreement — the LLC's counterpart to the partnership agreement of §1.2.2. As with a partnership, a written agreement prevents disputes and keeps default state rules from deciding questions the members never addressed.
Definition 1.3.2 — Filing the articles of organization is what brings the LLC into existence and raises the wall between business and member.
An operating agreement is the contract among an LLC's members governing how the LLC is managed, how members contribute capital, and how profits and losses are allocated. It plays the same role for an LLC that a partnership agreement plays for a partnership.
As you will see in Chapter 2, keeping the LLC's finances separate from the members' personal finances — a dedicated business bank account, no commingling — is also essential. Sloppy separation can let a court "pierce the corporate veil" and strip away the very liability protection the LLC was formed to provide, which is the subject of the next subsection.
Definition 1.3.3 — The operating agreement is the members' own rulebook for management, capital, and the allocation of profits and losses.
Alexis Delgado is opening a one-person graphic-design studio in Stockton. They expect roughly $9,000 of profit in their first year and are deciding between operating as a sole proprietorship and forming a single-member LLC.
a) Which of the two structures requires a filing with the state before the business legally exists, and what is that filing called? b) Name one recurring California cost the LLC would carry that the sole proprietorship would not. c) Alexis says, "I'll form the LLC but skip the operating agreement — I'm the only member, so there's nobody to agree with." Give one reason they should adopt one anyway.
Solution
a) The LLC. A sole proprietorship comes into existence automatically when Alexis starts doing business — there is no formation filing. An LLC is a creature of state law and exists only once Articles of Organization are filed with the California Secretary of State and the fee is paid.
b) The annual franchise tax. California charges every LLC doing business in the state a minimum annual franchise tax, owed to the Franchise Tax Board, whether or not the business profits. (Higher-revenue LLCs also owe an additional gross-receipts fee.) A sole proprietor pays neither. They would also owe the periodic Statement of Information filing, which a sole proprietorship does not.
c) It documents that the LLC is a real, separate entity. The operating agreement is part of the paper trail showing Alexis respects the entity — which is exactly what keeps a court from "piercing the veil" and reaching their personal assets. It also sets out in advance how capital contributions and distributions work, and it governs the LLC in place of the state's default rules if they later add a member.
Answer: Only the LLC requires a formation filing (Articles of Organization); the LLC carries the recurring franchise tax; and even a single member should adopt an operating agreement to keep the entity — and its shield — respected.
1.3.2 Liability protection
The central reason owners choose an LLC is limited personal liability. Similar to a corporation, an LLC limits a member's exposure to the debts and actions of the business. Absent a personal guarantee, a creditor of the LLC generally cannot reach a member's personal assets — savings, home, car — to satisfy the company's obligations. A member's risk is effectively capped at what they have invested in the business.
This is precisely the protection that a sole proprietorship and a general partnership do not provide. In those forms, as §1.1 and §1.2 showed, the owners can be held personally responsible for the business's unpaid obligations and sued to pay them. The LLC delivers a corporate-style shield while preserving the operational simplicity and pass-through taxation of a partnership — which is the whole appeal of the form.
Two cautions keep this protection real rather than theoretical:
- The shield is not absolute. It generally does not protect a member from liability for their own wrongful or negligent acts, and lenders to a small or new LLC often require members to sign a personal guarantee, which voluntarily sets the shield aside for that specific debt.
- You must respect the entity. Commingling business and personal funds, failing to keep the LLC adequately capitalized, or ignoring required filings can lead a court to disregard the LLC and hold members personally liable.
That second caution has a name, and it is worth knowing before you rely on the shield.
Piercing the corporate veil is a court's decision to disregard the separateness of a business entity and hold its owners personally liable for the business's obligations. It typically follows from commingling business and personal funds, inadequate capitalization, or a failure to observe the entity's required filings and formalities.
Maintaining the separation described in §1.3.1 and Chapter 2 is what keeps the protection intact. Notice the pattern: the LLC's shield is not something you buy once at formation — it is something you keep by continuing to treat the business as a business.
Definition 1.3.4 — Piercing the corporate veil: a court disregards the entity and lets a creditor reach the members personally.
Thuy Nguyen is the sole member of an LLC that runs a small catering company with her wife. Over the year she pays her home mortgage straight out of the LLC's checking account, never opened a separate personal account, and skipped the LLC's Statement of Information filing. The LLC is then sued for $70,000 after a delivery van accident caused by an employee, and the business has $15,000 in assets.
a) If Thuy had respected the entity, how much of the $70,000 could the creditor pursue from her personal assets? b) Given what she actually did, what argument will the creditor make, and what is it called? c) Would the LLC's shield have protected Thuy if she personally had caused the accident by driving negligently?
Solution
a) None of it. The LLC's shield caps a member's exposure at what they put into the business. The creditor could reach the LLC's $15,000 of assets, and the remaining $55,000 would go unpaid — her home, savings, and car would be off limits.
b) That the LLC should be disregarded — "piercing the corporate veil." Paying a personal mortgage out of the business account is textbook commingling, and skipping the required Statement of Information shows the entity's formalities were ignored. Together those facts let the creditor argue the LLC was never really operated as a separate business, so Thuy should answer for its debts personally.
c) No. The shield never covers a member's own wrongful or negligent acts. If she had been the negligent driver, she would be personally liable for her own conduct regardless of how carefully she maintained the LLC — the shield protects her from the business's obligations, not from her own.
Answer: A properly maintained LLC would have capped Thuy's loss at her investment; her commingling and missed filings invite a veil-piercing claim; and the shield would never have covered her own negligence in any case.
1.3.3 Flexibility of tax election
An LLC's most distinctive feature is that federal tax law does not assign it a single tax treatment. For income-tax purposes an LLC may be classified — by default or by affirmative election — as a partnership, a corporation, an S corporation, or a disregarded entity. This flexibility is what lets an owner keep pass-through taxation while enjoying a liability shield, and later switch tax treatment as the business grows without changing the underlying legal entity.
Default classification (no election filed). If the members file nothing, federal law assigns a classification based purely on how many members there are:
- An LLC with at least two members is classified as a partnership for federal income tax purposes — it files Form 1065 and passes income through to the members on Schedule K-1, exactly like the partnership in §1.2.3.
- An LLC with only one member is treated as a disregarded entity — "disregarded as separate from its owner." For income tax it is simply ignored, and its income and expenses are reported directly on the owner's return. (For employment tax and certain excise taxes, however, a single-member LLC is treated as a separate entity under its own name and EIN.)
A disregarded entity is a business — typically a single-member LLC — that is ignored as separate from its owner for federal income tax purposes, so its income and expenses are reported directly on the owner's return. The same business is still treated as a separate entity, under its own name and EIN, for employment tax and certain excise taxes.
A single-member LLC is like a person wearing a name tag only at work. For income tax the IRS looks straight through the LLC to the owner. For payroll tax it reads the name tag and deals with the LLC itself. Same business, two different answers — that is the confusion this rule causes.
A single-member LLC classified as a disregarded entity files no income tax return of its own. Its activity is reported on the owner's return — for an individual owner, on Schedule C, E, or F with Form 1040 — and the owner pays self-employment tax in the same manner as a sole proprietor.
Definition 1.3.5 — A single-member LLC is looked through for income tax but treated as a separate employer for payroll tax.
Ari Solano owns a single-member LLC and does not elect corporate treatment, so it is a disregarded entity for income tax. They run the shop alongside their wife, and the LLC has three employees — Marisol, Deandre, and Kiran — to whom it pays wages.
a) Which return reports the LLC's income, and who pays the tax on it? b) Who is responsible for the payroll taxes on Marisol's, Deandre's, and Kiran's wages — Ari personally, or the LLC? c) Is Ari an employee of their own LLC?
Solution
a) Ari's personal return; Ari pays. Because the LLC is disregarded, it is treated as their sole proprietorship for income tax. They report its income and expenses on Schedule C and figure self-employment tax on Schedule SE, both filed with their Form 1040. The LLC files no income tax return of its own.
b) The LLC. For employment tax the LLC is treated as a separate entity. Under its own name and EIN it is liable for income-tax withholding, FICA, and FUTA on the wages paid to Marisol, Deandre, and Kiran, and it must file the employment-tax returns and furnish each of them a Form W-2.
c) No. Ari is not an employee of their own LLC — they are self-employed, and they owe SE tax on their net earnings from the LLC's activities rather than having tax withheld from a paycheck.
Answer: Income tax flows to Ari personally (Schedule C and Schedule SE), while payroll tax obligations belong to the LLC under its own EIN. This split — disregarded for income tax, respected for payroll tax — is a common source of confusion, and it previews the trust-fund payroll obligations you will study in Chapter 5.
Elected classification (a form is filed). Rather than accept the default, an LLC can elect to be taxed as a corporation:
- File Form 8832 to elect classification as a C corporation.
- File Form 2553 to elect classification as an S corporation (a separate Form 8832 is not required first — filing Form 2553 is deemed to elect corporate classification as well).
The tax consequences follow the classification chosen. If the LLC is taxed as a C corporation, it pays corporate income tax and distributions to members are taxed again at the member level — the double taxation of §1.5.1. If it is taxed as an S corporation, the entity generally pays no income tax and its income, deductions, gains, losses, and credits pass through to the members. After choosing a classification, an LLC can later elect to change it, subject to the rules on subsequent elections.
Two LLCs each want to leave their default classification behind.
a) Wanda and Sylvester want their LLC taxed as a corporation, but not as an S corporation. What do they file, and how will the LLC's profits be taxed? b) Evelia and Carmen Rosales want their LLC taxed as an S corporation. What do they file, and must they file Form 8832 first?
Solution
a) File Form 8832; the profits are taxed twice. Absent an election, their two-member LLC defaults to partnership treatment. Filing Form 8832 elects classification as a C corporation, so the LLC pays corporate income tax on its profits and any distribution to Wanda and Sylvester is taxed again on their personal returns — the double taxation developed in §1.5.1.
b) File Form 2553; no separate Form 8832 is needed. Filing Form 2553 elects S corporation status, and that filing is deemed to elect corporate classification as well. As an S corporation the entity generally pays no income tax; its income, deductions, gains, losses, and credits pass through to them.
Answer: Form 8832 buys corporate (C) treatment and double taxation; Form 2553 alone buys S corporation treatment and keeps a single layer of tax.
Summary of LLC tax classifications. The table below collects the four treatments introduced above for quick reference:
| Members | Election filed | Taxed as | What that means |
|---|---|---|---|
| One | None (default) | Disregarded entity | No return of its own; income reported on the owner's Schedule C, E, or F |
| Two or more | None (default) | Partnership | Files Form 1065; income passes through on Schedule K-1 |
| Any number | Form 8832 | C corporation | Entity pays corporate tax; distributions taxed again (double taxation) |
| Any number | Form 2553 | S corporation | Generally no entity-level tax; income passes through to members |
Why this matters for entity choice. The LLC's tax flexibility is a genuine planning tool. A one-owner business can start as a disregarded entity (simplest possible taxes), keep its liability shield, and later elect S-corporation treatment once profits are high enough to make the S corporation's payroll/distribution split worthwhile (§1.4.2) — all without dissolving and re-forming. That adaptability, layered on top of limited liability, is why the LLC is so often the recommended structure in the case studies of §1.6.
For each LLC below, state its default federal income tax classification and which return, if any, the LLC itself files.
a) Rico Villanueva is the only member of his bookkeeping LLC and files no election. b) Lourdes and Danilo Reyes are the two members of a food-truck LLC and file no election. c) The same food-truck LLC later files Form 2553. d) Rico's LLC has two part-time employees. Does the answer in (a) change who owes the payroll taxes?
Solution
a) Disregarded entity; the LLC files no income tax return. A single-member LLC with no election is disregarded as separate from its owner. Rico reports the business's income and expenses on Schedule C with his Form 1040 and pays self-employment tax on Schedule SE.
b) Partnership; the LLC files Form 1065. An LLC with at least two members defaults to partnership classification. It files the Form 1065 information return and issues Lourdes and Danilo each a Schedule K-1, which they carry to their personal returns — no tax is paid at the entity level.
c) S corporation. Filing Form 2553 elects S corporation treatment, and that filing is deemed to elect corporate classification too, so no separate Form 8832 is required. The entity generally pays no income tax and its income passes through to them.
d) No — the LLC owes them. "Disregarded" applies only to income tax. For employment tax the LLC is treated as a separate entity under its own name and EIN, so his LLC — not Rico personally — is liable for withholding, FICA, and FUTA on the employees' wages and must file the employment-tax returns.
Problem Set 1.3
Problem 1. An LLC is often described as combining the best features of a corporation and a partnership. Name the feature it borrows from each, and explain which body of law supplies each one — state or federal.
Solution
From the corporation it borrows limited liability. Like a corporation's shareholders, an LLC's members are generally not personally responsible for the business's debts — a creditor can reach what the members put into the business, not their homes or savings.
From the partnership it borrows management flexibility and pass-through taxation. There is no board of directors and no mandatory corporate formalities; the members write their own operating rules. And by default the entity pays no income tax of its own — the income passes through to the members.
Which body of law supplies each. This is the distinction that makes the LLC unusual: state law creates the entity and supplies the liability shield (the articles of organization you file with the California Secretary of State), while federal tax law supplies the tax treatment and lets the LLC choose among several classifications.
Answer: Limited liability comes from the corporation side and is granted by state statute; management flexibility and pass-through taxation come from the partnership side, and the tax classification is governed by federal law.
Problem 2. A sole proprietorship comes into existence automatically; an LLC does not. Explain what an LLC owner must file to create the entity, and why that filing matters for liability rather than being mere paperwork.
Solution
What must be filed: Articles of Organization, filed with the California Secretary of State along with the filing fee. Until that filing is accepted, the LLC does not legally exist. (An initial Statement of Information follows shortly after, and periodically thereafter.)
Why it matters for liability, not just paperwork: the filing is what creates a separate legal person. The liability shield exists only because there are now two parties — the business and the member — instead of one. A sole proprietorship never separates from its owner, which is exactly why the owner answers for every business debt personally.
Put differently: the paperwork is the wall. Filing the articles builds it, and keeping the entity in good standing (Statements of Information, franchise tax, no commingling) is what keeps it standing. Skip the filing and there is no wall to hide behind, no matter what the business calls itself.
Answer: The owner must file Articles of Organization with the California Secretary of State. That filing matters because it brings a legally separate entity into existence — and the separation between business and owner is the liability protection.
Problem 3. Explain the California annual franchise tax in your own words. Why can it make an LLC the wrong choice for a very small or barely profitable business, even though the liability protection is attractive?
Solution
What it is. California charges every LLC doing business in the state a minimum annual franchise tax, owed to the Franchise Tax Board (FTB), for the privilege of operating as an LLC in California. It is not a tax on profit — it is a tax on existing. LLCs above certain revenue thresholds owe an additional fee based on gross receipts on top of the minimum.
Why it can make the LLC the wrong choice. Almost every other business cost scales with the business: no sales means no sales tax, no profit means no income tax. The franchise tax does not scale. A business that lost money all year still owes the minimum.
So the LLC's protection is not free — it costs a guaranteed amount every year. For a business earning a few thousand dollars of profit, that fixed cost can eat a large fraction of the earnings, and the owner may reasonably decide that a sole proprietorship plus a good liability insurance policy is the better trade. For a business with real assets, real debts, or real exposure to being sued, the same fixed cost is cheap insurance.
Answer: The franchise tax is a minimum yearly tax owed to the FTB whether or not the LLC profits. Because it is fixed rather than proportional to income, it can consume much of a very small or barely profitable business's earnings — so the shield may not be worth its price at that scale.
Problem 4. For each situation, state whether the member's personal assets are at risk, and why:
a) An LLC cannot pay a $40,000 supplier invoice, and the member signed no personal guarantee.
b) An LLC cannot repay a bank loan the member personally guaranteed.
c) A member personally injures a customer through their own negligence while working for the LLC.
d) A member has paid personal expenses out of the LLC's bank account for two years and never filed the required Statements of Information.
Solution
a) Not at risk. This is the LLC's core protection working exactly as intended. Absent a personal guarantee, a creditor of the LLC cannot reach a member's personal assets. The supplier can pursue the LLC's assets for the $40,000; anything unpaid beyond that goes uncollected.
b) At risk. A personal guarantee is the member voluntarily setting the shield aside for that specific debt. The member promised to answer for the loan personally, so the bank can pursue their personal assets if the LLC cannot repay. (Lenders to small or new LLCs commonly require this, which is why the shield is often thinner in practice than it looks on paper.)
c) At risk. The shield never covers a member's own wrongful or negligent acts. The LLC protects a member from the business's obligations, not from personal responsibility for harm they personally caused.
d) At risk. These are the classic grounds for piercing the corporate veil — commingling personal and business funds, plus ignoring the entity's required filings. A court can conclude the LLC was never really operated as a separate business and hold the member personally liable for its debts.
Answer: (a) protected; (b), (c), and (d) all expose the member's personal assets — respectively by contract (personal guarantee), by their own tort, and by veil-piercing.
Problem 5. Explain piercing the corporate veil in your own words, and describe two specific habits an LLC member should maintain to prevent it.
Solution
In plain terms: "piercing the corporate veil" is a court deciding to ignore the line between the business and its owners. Normally the LLC is treated as its own legal person, so its debts are its own. When a court pierces the veil, it says in effect, "this was never really a separate business," and lets creditors collect from the owners personally — the shield disappears retroactively.
Why courts do it: the protection is granted on the understanding that the owner will genuinely treat the business as separate. Commingling funds, leaving the business badly undercapitalized, or skipping required filings are all evidence that the owner did not hold up that end, so the court declines to hold up the other end.
Two habits that prevent it (any two of these):
- Keep a dedicated business bank account and never pay personal expenses from it. Every personal charge run through the business account is direct evidence of commingling. Pay yourself a distribution into your personal account, then spend from there.
- Keep every required filing current. File the Statements of Information on time and pay the annual franchise tax. A lapsed entity is an easy target for the argument that the formalities were never observed.
- (Also acceptable:) capitalize the business adequately rather than leaving it with no assets to meet foreseeable obligations; sign contracts in the LLC's name (as "member" or "manager"), not your own; and keep an operating agreement and business records.
Answer: Piercing the veil is a court disregarding the LLC's separateness to hold members personally liable, typically after commingling, undercapitalization, or ignored formalities. Two preventive habits: maintain a strictly separate business bank account, and keep all required state filings and franchise-tax payments current.
Problem 6. State the default federal income tax classification for each LLC, and name the return the LLC itself files (if any):
a) An LLC with one member.
b) An LLC with four members.
c) An LLC with two members that files Form 8832.
d) An LLC with two members that files Form 2553.
Solution
a) One member → disregarded entity; the LLC files no income tax return. It is "disregarded as separate from its owner" for income tax, so the income and expenses go straight onto the owner's return (Schedule C, E, or F with Form 1040).
b) Four members → partnership; the LLC files Form 1065. Any LLC with at least two members defaults to partnership classification. Form 1065 is an information return — no tax is paid with it — and each member receives a Schedule K-1 to carry to their personal return.
c) Two members filing Form 8832 → C corporation; the LLC files Form 1120. Note this is no longer a default: Form 8832 is an affirmative election out of the partnership default. The entity now pays corporate income tax, and distributions to the members are taxed again on their personal returns — double taxation.
d) Two members filing Form 2553 → S corporation; the LLC files Form 1120-S. Form 2553 alone is enough; it is deemed to elect corporate classification as well, so no separate Form 8832 is needed. The entity generally pays no income tax and its income passes through to the members.
Answer: (a) disregarded entity, no return; (b) partnership, Form 1065; (c) C corporation, Form 1120; (d) S corporation, Form 1120-S. Only (a) and (b) are true defaults — (c) and (d) are elections.
Problem 7. Marcus Boateng is the sole member of a landscaping LLC he runs with his husband, and he has just hired two employees. His LLC is a "disregarded entity" for income tax but a separate entity for employment tax. Explain what each half of that sentence means for him, and name the taxes that fall on each side of the line.
Solution
"Disregarded entity for income tax" — the LLC is invisible. For income tax the IRS looks straight through Marcus's LLC to Marcus. The LLC files no income tax return of its own. He reports the landscaping business's income and expenses on Schedule C with his Form 1040, and he figures self-employment (SE) tax on Schedule SE. He is not an employee of his own LLC — he is self-employed, so no tax is withheld from what he takes out, and he should be making quarterly estimated payments.
"Separate entity for employment tax" — the LLC is visible. The moment he hires the two employees, the LLC becomes an employer in its own name and under its own EIN. The LLC — not Marcus personally — is responsible for withholding federal and state income tax and the employees' share of FICA from their wages, paying the employer's matching share of FICA, paying FUTA, filing the employment-tax returns, and furnishing each employee a Form W-2.
The taxes on each side of the line:
- Income-tax side (flows to Marcus personally): income tax on the business's profit, plus self-employment tax on his net earnings — reported on Schedule C and Schedule SE.
- Employment-tax side (belongs to the LLC): income-tax withholding, FICA (employee share withheld plus employer match), and FUTA on the two employees' wages.
Answer: For income tax the LLC is ignored and everything lands on Marcus's own Form 1040 (Schedule C plus SE tax). For employment tax the LLC is a real, separate employer under its own EIN, owing withholding, FICA, and FUTA on its employees' wages and filing the payroll returns. The money he withholds from those paychecks is held in trust, not earned — the trust-fund obligation developed in Chapter 5.
Key Terms
limited liability company (LLC) — a business structure created by state statute whose owners have limited personal liability while the business keeps management flexibility and, by default, pass-through taxation.
member — an owner of an LLC; may be an individual, a corporation, another LLC, or a foreign entity, with no maximum number.
single-member LLC — an LLC with just one owner, permitted in California and most other states.
articles of organization — the formation document filed with the state that brings an LLC legally into existence.
Statement of Information — the periodic filing an LLC must make with the state to remain in good standing.
franchise tax — California's minimum annual tax owed to the Franchise Tax Board for the privilege of doing business in the state, due whether or not the LLC profits.
operating agreement — the contract among an LLC's members governing management, capital contributions, and the allocation of profits and losses.
personal guarantee — a member's voluntary promise to answer personally for a specific business debt, setting the liability shield aside for that debt.
piercing the corporate veil — a court's decision to disregard the entity's separateness and hold owners personally liable, typically after commingling, undercapitalization, or ignored formalities.
disregarded entity — a single-member LLC ignored as separate from its owner for income tax, though still a separate entity for employment and certain excise taxes.
Form 8832 — the federal form an LLC files to elect classification as a C corporation.
Form 2553 — the federal form an LLC files to elect classification as an S corporation; it is deemed to elect corporate classification as well.