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Tax Aspects of Limited Liability Companies

The limited liability company (LLC) is a hybrid of a corporation and a limitedpartnership that is created under state law. For federal tax purposes, an LLC istreated identically to a partnership and it must file a Form 1065, U.S.

Partnership Return of Income. (There is an exception to this rule for single-owner LLCs, which are treated identically to sole proprietorships and whoseowners must simply file a Schedule C with their Form 1040.)

Under state laws, LLC owners are given the protection from liability that waspreviously afforded only to corporate stockholders. Although the LLC is arelatively new business form, every state has enacted legislation providing forlimited liability companies.

Formerly, the IRS had treated limited liability companies as partnerships ratherthan as corporations only if the business did not possess more than two of four

characteristics of corporations: centralized management, continuity of life, freetransferability of interests, and limited liability. Under regulations that went intoeffect at the start of 1997, newly formed LLCs can obtain partnership taxtreatment even if they have all four corporate characteristics; in fact an LLC willbe presumed to have partnership treatment unless it elects to be treated as acorporation.

However, while LLCs are treated as partnerships for federal tax purposes, thesame is not always true for state tax purposes. You'll need to check yourstatetax laws.

Comparison with S corporations. While S corporations also provide limitedliability for their owners and favorable pass-through tax treatment, LLCs doprovide some additional advantages to growing businesses. Like a partnership,an LLC has the ability to make disproportionate distributions to its owners (forexample, a LLC member may have a 50 percent ownership interest in LLCassets but be entitled to 60 percent of the income, if the operating agreement soprovides). In contrast, S corporations must generally make all distributions pro-rata in accordance with the number of shares held by each owner. An LLC canhave an unlimited number of investors, whereas an S corporation is limited to100 shareholders.

Other factors to consider. There are a number ofnontax factors that mayinfluence your decision as to whether a LLC is the right form of business foryou, and we recommend that you seek legal advice in setting up a LLC andwriting up the operating agreement.

Businesses that are engaged in operations that are considered "risky" orsubject to frequent lawsuits are often encouraged by their legal advisors toincorporate. Moreover, the corporate structure can make it much easier toobtain investment capital and to pass the business down to the owner's childrenor other successors upon death or retirement.

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From a tax perspective, there are two options for corporations under federalincome tax law:

C corporations are what we normally consider "regular" corporations thatare subject to the corporate income tax.

S corporations are corporations that have filed a special election with theIRS. They are not subject to corporate income tax, but are treated as similar(but not identical) to partnerships for tax purposes.

There are a number ofnontax factors that may influence your decision as towhether a corporation is the right form of business for you, and we recommendthat you seek expert legal advice in setting up a corporation and writing up thearticles of incorporation.

C Corporation Taxes

A regular corporation (also known as a C corporation) is taxed as a separateentity. Income earned by a corporation is normally taxed at the corporate levelusing the corporate income tax rates shown in the table below, and thecorporation must file a Form 1120 each year to report this income.

After the corporate income tax is paid on the business income, any distributionsmade to stockholders are taxed again at the stockholders' tax rates asdividends. Because of these two levels of tax, a regular corporation may be aless desirable form of business than the other business entities (soleproprietorships, partnerships, limited liability companies, or S corporations).

Comparison with partnerships or sole proprietorships. Because thetaxation of income to sole proprietorships and partnerships is determined by thetax bracket that applies to each individual owner, a comparison of tax rates thatapply to corporations and to individuals can give you some idea of which form ofbusiness would save taxes at a particular income level.

The following chart compares the marginal tax rates for tax years beginning in2009 for corporations, married individuals filing jointly, and for singles.

Taxable Income ($) C Corp. Married/Joint Individual

1-8,350 15% 10% 10%

8,351-16,700 15% 10% 15%

16,701-33,950 15% 15% 15%

33,951-50,000 15% 15% 25%

50,001-67,900 25% 15% 25%

67,901-75,000 25% 25% 25%

75,001-82,250 34% 25% 25%

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addition to the regular corporate tax. Virtually any corporation can accumulateup to $250,000 in retained earnings without becoming subject to this tax.

Transactions between corporations and owners. Transactions between aclosely held corporation and its stockholder-owners will be closely examined by

IRS agents. If corporate property is diverted to the stockholders, they will beconsidered to have received what is called a "constructive" or "preferential"dividend. This tax treatment is highly unfavorable, since this dividend will betaxable to the owners and will not be deductible to the corporation.

The most common type of preferential dividend received by stockholdersinvolves the payment of personal expenses on behalf of stockholders. Typically,the corporation claims deductions for these expenses as business expenses onits income tax return, but where the expenses are clearly personal expenses,the corporation will be denied a deduction and the officer-stockholder will bedeemed to have received a taxable dividend.

Stockholders are also considered to have received constructive dividendswhen: (1) corporate property is sold to a stockholder at less than its fair marketvalue, (2) employee-stockholders are given unreasonably high compensation,(3) the corporation pays excess rents to shareholders for property leased by thecorporation, or (4) the corporation loans the shareholder funds and there is nointention to repay the loan.

Corporate Alternative Minimum Tax. Like individuals, corporations canbecome subject to an Alternative Minimum Tax (AMT) if they have gained thebenefit of "too many" tax preference items. As of 2009, the corporate AMT willnot apply to any corporation if (1) the corporation is in its first year of existenceor(2) the corporation was treated as a small corporation exempt from AMT forall prior tax years after 1997 and its average annual gross receipts for the lastthree years ending before the 2009 tax year did not exceed $7.5 million ($5million if it only existed for one prior year). For corporations that are subject toAMT, the general rate is 20 percent (the rate is reduced to 15 percent for certainspecific items).

S Corporation Taxes

An S corporation is a creature of the federal tax laws. For all other purposes, it'streated as a regular corporation. So, to form an S corporation you first have toincorporate under state law.

Then, you must file a special IRS form electing to be taxed similarly to apartnership. This election preserves the corporation's limited liability under statelaw but avoids taxation at the corporate level. This means that income andlosses of the S corporation are passed through to shareholders in much thesame manner as a partnership passes through such items to partners.

One important difference between partnerships and S corporations is that in the

S corporation all profits, losses, and other items that pass through must beallocated according to each shareholder's proportionate shares of stock; so, if

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you own 50 percent of the stock, you must receive 50 percent of the losses,profits, credits, etc. This is not the case with a partnership or an LLC, where onepartner or member can receive different percentages (or changing percentagesover time) of different tax items if the operating agreement so specifies.

S corporation requirements. Although the tax laws don't limit S corporationstatus to small corporations in terms of revenue, the requirements for electingcan make it difficult to operate a large business as an S corporation. To obtainS corporation status under the federal income tax law, all of the followingrequirements must be met:

The corporation must be a domestic corporation (a corporation organizedunder the laws of the United States, a state, or territory that is taxed as acorporation under local law). All shareholders must agree to the election. The corporation may not have more than one class of stock (voting and

nonvoting shares are not considered to be two separate classes, however. The corporation may not have more than 100 shareholders. The corporation may not have any shareholder that is a nonresident alienor nonhuman entity (such as other corporations or partnerships), unless theshareholder is an estate or trust that is authorized to be an S corporationshareholder under the tax laws. Certain exempt organizations, such asqualified pension, profit-sharing, and stock bonus plans, or charitableorganizations will be allowed to be shareholders in an S corporation (forpurposes of determining the number of shareholders of an S corporation, aqualified tax-exempt shareholder counts as one shareholder). Prior to 1997, an S corporations could not have subsidiaries, and couldnot be a member of an affiliated group of corporations. As of 1997, an Scorporation can hold qualifying wholly owned subsidiaries and can own 80percent or more of the stock of a C corporation. The C corporationsubsidiary can elect to join in the filing of a consolidated return with itsaffiliated C corporations, but the S corporation cannot join in the election.