Most legal entities are required to pay federal income taxes on earnings but at different rates. The decision about legal structure can affect thousands, even hundreds of thousands, of dollars over time, complicating an individual’s retirement, gift, and estate planning.
Both forms have the flexibility to assign and distribute profits and losses by any method acceptable to the partners or shareholders.
Partnerships and LLCs taxed as partnerships are “pass-through” entities, meaning that profits and losses are distributed to individual partners in a Partnership or individual shareholders in the LLC. This feature avoids the double taxation that occurs in traditional corporations.
There may be circumstances where paying taxes advantageous such as a desire to retain earnings in the business or implement an IPO. The LLC gives founders greater flexibility to choose or change filing status not possible in a partnership.
An LLC’s ability to change tax treatment is a significant advantage for startup companies, especially those focusing on growing revenues in the early years. For example, ABC LLC elects to be taxed as a partnership until it produces a profit.
Many startups incur losses in their early years due to the heavy expense of “scaling” – growing revenues as quickly as possible. Being taxed as a partnership enables the business to distribute losses pro-rata to shareholders, potentially offsetting other personal revenue. When the business begins to make profits, the company elects a corporation tax treatment.
A drawback of LLC structures is the IRS prohibition of paying a salary or wage to a member if the LLC is treated as a partnership. However, a member may receive a “guaranteed payment” to replace the lost salary:
“Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership’s income. A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner.
This treatment is for purposes of determining gross income and deductible business expenses only. For other tax purposes, guaranteed payments are treated as a partner’s distributive share of ordinary income. Guaranteed payments are not subject to income tax withholding.”