LLC’s – Pros and Cons of Entity Election and IRS Penalty Assessments

Everyone seems top be a bit confused when it comes to issues with LLC’s and filing. The basic rules are : A 1 person LLC defaults to a sole proprietorship, two or more person LLC defaults to a partnership. An LLC can elect to be a Corporation no matter how many people in the LLC. There is a form that the election can be made on. If the LLC prefers to be an S Corp they need to simultaneously file the S Election with the Corporate election.

Logically there is no reason to choose to be an S Corp if you are a two or more person LLC as both a Partnership and S Corp act exactly the same for tax purposes. Both are pass-through entities that are taxed at the partner or shareholder level. This does not preclude the partners from doing so if they prefer. It may be prudent to make the Corporate election certainly with the 2018 changes. Prior to 2018 most LLC’s preferred pass through status due to the double taxation of a Corporation, meaning the Corporation is taxed and the monies paid out of the corporation to the shareholders is also taxed to those individual shareholder’s.

I have discussed the pros and cons of Corporate election verses pass through and the law changes in a prior blog. The current maximum tax for a Corporation is now 21%, however, this may only be beneficial if the Corporation does not expect to disburse funds to the shareholders due to the double taxation.

This week an issue came up about penalties assessed by the IRS for pass-through entities such as S Corps and partnerships. Several years past the IRS instituted an penalty on these entities for late filing. The penalty system currently at IRS is to assess penalties on tax returns that have a tax liability. Therefore, since partnerships and S Corps were pass through’s it is impossible for them to have their own tax liability therefore impossible for the IRS to assess a penalty.

The current penalties are based on late filing and assessed by the number of partners and/or shareholders and the amount of months delinquent. The penalty is quite substantial. The issue mostly comes up on a retroactive S Election. If an LLC has not filed for two years and wants to be an S corp, there is a way to do this called Retroactive S Election. The IRS allows it based on certain criteria, however, they have the right to access the penalty. The penalty can be avoided if an timely extension is filed in the year filing and therefore the year filing a penalty will not be assessed, however, the prior year penalty will be. The IRS generally will allow a one time removal of penalty. If an extension was not filed then the penalty will be assessed in the second year and one of the years penalties would have to be satisfied.

I hope this has clarified the issues. Please let me know if you have any further question regarding these matters.

Leave a Reply

Your email address will not be published. Required fields are marked *