Owners or members, as they are usually called, of an LLC have the choice to elect how the LLC will be treated for tax purposes. This is a fairly new option allowed by the tax regualtions. In the past, the Internal Revenue Service (IRS) classified business entities as either partnerships or corporations based on four different factors.

The four factors included: limited liability, centralized management, continuity of life and free transferability of interest. However, this "four factor" approach led to a lot of confusion and uncertainty for business owners.

Then in 1997, new IRS regulations came into effect which allowed business entities like LLCs to elect the tax treatment they desired. These regulations became known as the "check-the-box" regulations. They can be found in Income Tax Regulations 301.7701-1 through 301.7701-3. Details about making the election are set forth in the IRS instructions to Form 8832.

The change in the law provides several different options to entities such as an LLC. It will allow a business operated as an LLC to enjoy all of the beneficial characteristics of a corporation but still be taxed as partnership or, in the alternative, it provides for an LLC to elect corporation tax status and then make the S corporation election.

In summary, partnership taxation provides for the income and deductions to flow through or "pass through" to the partners who then report and pay income tax on their individual tax returns. Partnership taxation is the basic method of taxation for most LLCs and S corporations. On the other hand, if an entity is classified as a corporation, then income taxes will generally have to be paid by the corporation on income that it earns and then later when that income is paid to the shareholders in the form of dividends, they will have to pay tax at their personal level. This results in double taxation and needs to be avoided where possible.

The partnership form of taxation avoids this double tax and is one of the main reasons why it is beneficial to most small businesses. LLCs by default receive partnership taxation. This means if the owners do not make an election by filing Form 8832 to be taxed as something different than a partnership the LLC and its members will automatically be subject to partnership taxation principles. A corporation which makes the S election is also subject to the basic partnership taxation principles with a few exceptions. In other words, standard LLCs and S corporations are both treated similarly, with a few exceptions, based upon partnership taxation principles.

Most tax professionals I work with suggest that a business owner can reduce (not eliminate) the FICA or 15.3% self employment tax by forming a corporation and making the S election. However, this reduction in FICA taxes is not available in most cases to the members of an LLC. So a business person can form an LLC and then make the election to be taxed as a corporation by filing IRS Form 8832 and then make the S election by filing IRS Form 2553. By doing this, the LLC can operate with the less formal structure and rules associated with corporations but also obtain reduced FICA tax treatment for the members.

Since both the S corporation and the LLC provide limited liability protection to the shareholders or members, an LLC which elects tax treatment similar to the S corporation, may be an attractive option to discuss with your accountant or tax advisor. Not only can you operate the LLC under less stringent requirements than the corporate form, you still get limited liability protection, basic partnership taxation, with a few exceptions, the chance to reduce FICA taxes for the members of the LLC and operation of the LLC under less formal rules than with corporations.