This post builds on my previous post, The Corporate Personality Test, which is all about choosing the right legal structure for your business. This post zooms in on one of those entities, the limited liability company. It explores the nuances and the sometimes-complicated tax structure of the LLC. But before we get there—and in order to understand what makes the limited liability company so unique—you’ll need a general understanding of business associations.

Business Associations and State Law

Business associations are organizational structures through which owners invest capital in order to carry out a business purpose. Business associations run the gamut from complex multinational corporations to single-owner operations. But no matter their complexity, business associations are creations of state law. Every corporation, partnership, and limited liability company in existence has been chartered by a specific state (ignoring foreign entities and a few banks), and each exists under the laws of that specific state. For the most part, business association laws are uniform from one state to the next. Corporation rules in Ohio are similar to those in New York. Partnerships in Colorado look a lot like partnerships in Florida. With some exceptions–which can be very subtle and sometimes very important, so be careful!–corporate disputes will be resolved more-or-less the same from one state to the next.

The rights that we associate with the various business associations are state rights. The right to vote at a shareholder meeting, to seek judicial dissolution of a partnership, or to receive a share of LLC assets on liquidation—these are all state-created rights written into state-level statutes. These rights are tremendously important and they vary considerably from one entity type to the next. But they aren’t mandated or guaranteed by Federal law.

The most significant of these rights—a core distinction between the different business associations, which we’ll return to later—is the extent to which the owners of a business association are liable for the association’s debts. In a corporation, the owners are liable only to the extent of their initial investment—shareholders can lose everything they put into the company, but no more. In a partnership, however, the general partners face unlimited personal liability. This distinction is among the most important factors in choosing an entity. And it is a distinction made at the state level under state law.

Federal Tax Regimes

Even though business associations are not federal creations, no analysis of business associations would be complete without a look at the impact of federal taxes. This is where the confusion starts to creep in. Business entities are taxed by the federal government. No surprise there. But unlike natural persons—as the law quaintly calls human beings—different business entities are taxed not only at different rates, according to different tax brackets, but they are taxed under entirely different tax regimes. And those regimes do not line up with the types of entities created by state law.

So while the states have their corporations, partnerships (general and limited), limited liability companies, and whatever else a state may dream up (B-corps, anyone?), federal tax regimes are more limited. The federal government taxes business associations as corporations or partnerships. That’s it. Corporations are taxed as corporations. Partnership and limited liability companies are taxed as partnerships.

You may be asking, if there are only two tax regimes, where do S-corporations fit? S-corporations—small-business corporations taxed under subchapter S of the Internal Revenue Code—are one of many special-purpose corporations found in the Revenue Code. S-corporations are fairly elaborate and quite popular. But there are other examples of special-purpose corporations that are more specialized and less well known, like the Interest-Charge Domestic International Sales Corporation. These are all just corporations, more-or-less subject to the standard corporate tax regime—which isn’t to say the differences between them aren’t important. They are. But for our purposes, here, there are really only two tax regimes: corporations and partnerships.

So what is an LLC?

An LLC is a state created business association that is taxed by the federal government as a partnership. As noted above, at the state level, an LLC looks an awful lot like a corporation. The owners of an LLC are not personally liable for the obligations of the company (unless they sign a personal guarantee, or in some cases under a poorly drafted operating agreement or where certain formalities are disregarded). On the other hand, the organizational structure of an LLC—equity arrangements, voting rights, management, and so on—these all look like a partnership, which is to say they are highly customizable.

LLCs are relatively recent inventions. The first LLC statute was passed by Wyoming in 1977. Since then, every state has adopted an LLC statute. And owing primarily to the combination of structural flexibility and limited liability, LLCs have quickly become the most popular entity for new businesses.

But despite the popularity of limited liability companies, the federal government has not adopted an LLC tax regime. Instead, at the federal level, an LLC is taxed as a partnership. What that means is that the income of an LLC is not “double taxed,” as it is with a corporation—where the business income is taxed when it is earned and taxed again when it is distributed to the shareholders. (If it’s distributed to the shareholders.) Instead, the owners of the LLC (called the “members”) are taxed directly on their share of the income of the LLC. That’s how it works in a partnership. Each partner is taxed on his or her share of partnership income, and gets to claim his or her share of partnership deductions and loss.

But that’s just the default classification. To make things a bit more complex, in 1996 the IRS adopted “check the box” rules, which allow an LLC to essentially check a box on a form and elect to be taxed as a corporation. An LLC that has elected to be taxed as a corporation can further elect to be taxed as an S-corporation. So it’s perfectly possible to have an LLC that pays corporate or S-corporation tax.

Now, you may wonder why a business would choose to do that. Why would a business step back into the corporate tax regime after organizing as an LLC? Why not just start out with a corporation? The answer is that, as mentioned above, LLCs have a very flexible organizational structure. They don’t require a lot of corporate formality. And in some cases, corporate tax, or S-corporation tax, turns out to be more beneficial than the pass-through LLC tax. In fact, if you have employees and run a payroll, S-corporation tax is often advantageous because you can make certain cash distributions without paying self-employment tax. Under the “check the box” rules, an LLC gets to have all of the structural flexibility of a partnership, combined with whatever tax structure the business needs.

In other words, an LLC is a choose-your-own-tax entity with huge structural flexibility and liability protection for its owners. Sometimes this flexibility can lead to some pretty complicated tax scenarios. But even so, limited liability companies are quickly becoming the entity of choice for new businesses. After all, an LLC can adopt just about any type of the ownership structure it wants. It can pay whatever type of tax it wants. And its owners are protected from personal liability. The limited liability company is a fully customizable, built-to-order business association.