A Simple LLC Mistake That Creates Nightmares

Limited liability companies (LLC) are deceptively easy to form and use.

One of the realities of an LLC is that it is a structure under state law, while it can be taxed many different ways under federal law. This is part of its appeal, and a part of its deceptive complexity. Without some careful planning and work, it has a tendency to create costly mistakes for many small businesses.

One specific situation that can be problematic is when an LLC switches how it is taxed. Under IRS rules, an LLC can pick how it is taxed when it is formed (or simply accept the default), and it can change how it is taxed once any time after it is formed. However, after the LLC has made its “free” selection, it has to wait around 5 years before it can change its taxation election again.

What sometimes happens is that a business in an LLC form starts as a sole proprietor for taxation purposes, but then, as things go along, the owner takes on a partner. This requires that the LLC be taxed as a partnership which is a change of the taxation election. After a year, the partners decide to part ways as it is not working out, and the LLC now has only one member again. However, as far as the IRS is concerned, the LLC is still a partnership for taxation purposes, and under its rules, the owner cannot switch the LLC back to a sole proprietorship for taxation purposes.

Unaware of this reality, an owner may try to file their taxes as a sole proprietor, and the IRS will reject them and start charging fees and interest. Meanwhile, the owner continues to do business in an entity that is paradoxically defective in some way.

So what can the owner do? The short answer seems to be that, if caught early enough, the LLC can take on another partner so it matches its taxation election. The other option might be to dissolve the entity and start over with a different one. However, as you can imagine, this has its own set of problems or an existing business. Each situation is different and needs to be evaluated.

This example illustrates how business owners can benefit from good advisors during the life of the business so they do not fall into costly, time consuming, difficulties that could easily be avoided with the right expertise.