The limited liability afforded by the LLC formation is a very obvious benefit that it offers. In addition, there can also be tremendous benefits based on the flexibility by which the LLC can be taxed. Members of an LLC can, via the “check box” method, elect to have their LLC taxed as either a C corporation or, by timely filing the 2553 form, as an S corporation. By default an LLC is taxed as a sole proprietorship if it is a single-owner LLC, or as partnership if it has two or more owners. All options should be examined to determine which method provides the greatest tax relief. Regardless of the method of taxation, the legal liability shield remains in place.
Entity Classification Selection (Filing Form 8832)
The IRS has created a form to deal with the manner in which an LLC is to be treated for taxation purposes: the “check the box” form, form 8832. It greatly simplifies the once complicated process of allowing the LLC members to elect how they would like their entity to be treated for tax purposes. Both single and multiple member LLCs may use the form. Though most often times multiple member LLCs wish to be treated as an S corporation or partnership in order to benefit from the pass-through taxation, this should not automatically be assumed as, ideally, members of all tax-classifications of LLCs may be best-served to file form 8832 as an affirmative selection of the manner in which they want their entity to be taxed.
LLC Taxed as a Partnership or S Corporation
LLCs with more than one member are usually classified as a partnership for tax treatment purposes, though it is not mandated. A multiple member LLC can elect to be treated as a C or S corporation, but it would lose the pass-through taxation benefits afforded the partnership tax treatment with C corporation tax treatment, and is limited with respect to how many members it can have and prevents non-citizen/resident alien ownership with the S corporation taxation. Subject to the subchapter K of the Internal Revenue Code governing the taxation of partners and partnerships, electing to have your LLC taxed as a partnership would subject it only to a single Federal Income Tax at the partner level, with each member reporting his share of each item in the LLC’s gain, loss, income, deduction, or credit on his personal tax return.
The restrictions on the equity and capital structure of an S corporation can significantly limit the flexibility in strategic planning for your company, especially for growth, changes in stock types, inter-generational business transfers, etc. Among these restrictions, for example, are the limitation that an S corporation can have no more than 75 shareholders, and that shareholders can only be individuals and estates (some trusts, but not other corporations). Another limitation is that an S corporation can only issue one class of stock, thus limiting one of the LLC’s flexibilities in that it can have varying levels of ownership interest.
Basis of Member Interest in the LLC
Members of LLCs taxed as Partnerships typically obtain basis in their LLC interest from the contributions/payments for their membership interest. Each member or partner has a basis in his partnership interest that is separate from the partnership’s basis in its assets. Partnership interest is treated as an interest in a separate entity comparable to stock in a corporation. A member must know the basis for his interest for a number of tax purposes, including:
- Computing his gain or loss when he sells or relinquishes the interest
- Computing his gain or loss on a distribution from the LLC
- Determining his basis in property distributed by the LLC
- Determining the maximum amount of partnership losses he may deduct
When Limited Liability Company membership interest is purchased, the purchaser can step up the tax basis of his/her unappreciated LLC assets to reflect the purchase price pursuant to internal revenue code Section 754. There is no similar adjustment provision available for purchasers of "S" or "C" corporate stock.
Distributions to Members
A member may generally receive distributions of partnership property without recognizing a gain or incurring a loss. The distribution is treated as a non-taxable withdrawal of the member’s investment up to the level of his interest in the membership.
A member does, however, recognize a gain on a current distribution if it exceeds his level of investment or interest in the LLC. A partner may not recognize a loss on a current distribution, though he may recognize a loss on a distribution that consists solely of liquid assets, cash, or unrealized receivables. The loss would be limited to the difference between a member’s basis for his interest and the sum of the distribution. These gains or losses are treated as capital gains or losses for taxation purposes.
Tax Consequences of Capital Contributions
Cash contributions to an LLC are not much different than a cash contribution to a corporation or partnership. No gain or loss is recognized, and the contributor’s basis for the stock or interest he receives is typically deemed to equal the amount of cash he contributes. Contributing property, however, has a significantly different impact. In an LLC, gain or loss in contributed property is deferred until the partnership sells that particular asset or the contributing member sells his or her share in the LLC. The contributing member does not recognize a gain or a loss at the time of contribution, irrespective of the percentage of his ownership allowed by the operating agreement. When the LLC sells the contributed property, the gain or loss that was not recognized initially is now recognized and allocated to the contributing member.
This is in direct contrast is the transfer of appreciated property in a C or S corporation in exchange for stock interest. In this instance the transaction is taxable unless the contributor controls the corporation through ownership of at least 80% of the stock.
In a C corporation, the corporation is taxable on any gain or loss when it disposes of the contributed property, though there would be no tax consequences to the shareholders. In an S Corporation, gain or loss that the corporation recognizes when it disposes of the property passes through to the shareholders in direct proportion to their stock ownership/investment. The gain or loss is not allocated to the contributing shareholder.
These scenarios exemplify why it is critical to understand the type of business in which your company will be engaging and what taxation model best suits your LLC.
Taxation of LLC Income and Loss
Speaking strictly in taxation terms, an LLC, when taxed as a partnership or sole proprietorship is not a separate tax-paying entity in the eyes of the IRS. Each member is separately and individually liable for the taxes on his share of the LLC (profits, losses, deductions, and credits). Each member must report his share of his tax liability, and each tax liability retains the same character it had when earned or incurred by the LLC. The pass through of items to members means that income avoids being double taxed, and losses may offset income that the member may have from other sources.
In direct contrast, a C corporation is a separate entity for even tax purposes and is such, is required to pay its own taxes. Income and profits are taxed at the corporate level when earned, then taxed again when distributed to the various shareholders as dividends. Dividends are always taxable as income, irrespective of the source. Therefore, when distributing corporate profit, it may be advantageous to pay the gain as salary or bonus rather than as a dividend, which is tax-deductible to the corporation.
S corporations are taxed in a somewhat similar fashion as are partnerships. The tax burden on retained earning in an S corporation passes through to the individual shareholders. Each shareholder reports his percentage share of the income on his tax return. However, the income can be re-characterized. For example, if the S corporation earns profits that would be taxed as ordinary income if earned by an individual, the S corporation can pay the earnings as a “distribution to shareholders.” When one received payment in this fashion, they can avoid Social Security and Medicare tax, currently a 15.3% tax savings. One must tread carefully with the LLC as an S corporation because the LLC may be taxed as a C corporation, even if the S corporation election is made, if the requirements are not met and it is operated like a “regular” corporation. For example, if the entity has even one foreign owner it will be deemed to be a C corporation for taxation purposes. Similarly, if excessive passive-type income is generated by corporate assets or if the corporation disposes of assets that had built in gain when the election was made to be treated as an S corporation, the IRS may see fit to tax the LLC as a C corporation.
Change in ownership of the corporate shares does not terminate a "C" or "S" Corporation for Federal Tax purposes, unless the change involves foreign owners. Because a multi-member LLC can be considered a Partnership, it is subject to the Termination Rule of IRC Section 708(b). An LLC terminates for Federal Income Tax law purposes whenever 50% or more of the interest in capital and profits are sold within a 12 month period. This means that even though the LLC may technically still be in existence under State Law, for tax purposes, it terminates and re-starts. This has the same effect establishing a new entity for accounting purposes, and brings the current LLC tax year to a close.