Tax Implications of LLCs and Corporations

April 13, 2006

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When comparing the limited liability company (LLC) and the corporation, you'll notice great differences in the ways each organizational form is charged state fees, operated under current law and taxed by the government.

For tax purposes, the LLC is treated as a sole proprietorship when there is one owner and as a general partnership when there are two or more owners. Neither the sole proprietorship nor the general partnership is a taxpaying entity. They are termed "pass-through entities," or conduits. The owners report their share of profit and loss (whether or not it is actually distributed) on their personal income tax returns.

The owner of a one-owner LLC must fill out Schedule C and add it to his or her personal income tax return (Form 1040); members of a multiple-owner LLC must use Schedule E with their returns. A multiple-member LLC also must file a partnership information return, Form 1065, which shows how the money came in and was distributed to members, but no entity-level taxes are imposed. "Salary" to the owner of an LLC is really just a way of dividing profits, or an owner's withdrawal in a one-owner LLC (see our discussion covering the different ways of dividing profits in the LLC).

In contrast, a corporation must file a separate tax return, Form 1120, and pay its own taxes. Salary for the corporation's employees, including owner/employees, is reported on their own tax returns, as are any corporate dividends.

The owner can reverse this taxation scheme, in both the LLC and the corporation. The LLC owner can elect to have the LLC treated as a corporation for tax purposes, by filing Form 8832 with the IRS.

Similarly, an owner of a corporation may elect to have the corporation treated similarly to a sole proprietorship or partnership for tax purposes, by filing Form 2553 with the IRS (the so-called "subchapter S" election). In this case, the S corporation would still have to file a tax return for the business (Form 1120S), but no taxes would be imposed on the business itself; the profits, losses and other tax items would be passed through to the owners and reported on their own Schedules E and Forms 1040.

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In 1997, the IRS clarified that, for tax purposes, the LLC would be treated as a sole proprietorship when there is one owner and a general partnership when there are two or more owners, unless an election is made to treat the LLC as a corporation for tax purposes under the so-called IRS "check-in-the-box" regulations.

Prior to this, there was some confusion as to how the LLC would be taxed, because the LLC has attributes of both a sole proprietorship/general partnership and a corporation. Accordingly, state laws and operating agreements artificially sought to achieve today's classification by requiring that the LLC have two or more owners, and a life of a limited duration (as opposed to the perpetual existence of a corporation).

Today, you don't need to take any action at all if you want your LLC to be treated as a sole proprietorship or partnership for tax purposes.

A common misunderstanding by small business owners concerns the relationship between taxation and limited liability. Many owners mistakenly believe that, because their LLC is treated as a sole proprietorship or general partnership for tax purposes, somehow this means that liability in the LLC mirrors liability in these other business forms. The same misunderstanding arises when a corporation elects subchapter S tax status.

Really, there is no relationship. Taxation has nothing to do with liability. All of the owners of the LLC and corporation enjoy limited liability. How the LLC or corporation is taxed is irrelevant to the question of liability.

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A number of states have announced that they will follow the lead of the IRS with respect to LLCs in assessing state income taxes. Thus, the LLC automatically will be presumed to be a conduit for state tax purposes in these states, and no state corporate tax is imposed.

States Treating LLCs as a Conduit for State Taxes
Arizona	Maryland	Tennessee
California	Minnesota	Utah
Maine	New Jersey

While other states are likely to take the same lead, this is a fast-developing area of law. It is wise to check with the state tax department in your state for the latest information.

If you form a corporation and then file an election to be taxed as an S corporation for federal purposes, don't automatically assume your state will recognize the federal election. In fact, while most states will follow the election in assessing state taxes, a few do not. In addition, a very few states impose a special tax on the income of every business, whatever its form. Always check with state taxing authorities in the state in which the entity will be formed, and the state in which it will be doing business, before choosing a business form and a state of formation.

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If a corporation is to be used, forming it as a statutory close corporation in Nevada completely eliminates the issue of state taxation, as Nevada has no income tax on corporations. Delaware has a corporate income tax, but it does not apply it to subchapter S corporations that are formed there but do no business there.

When making your ultimate decision on entity form, these specific tax issues should be considered:

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The accumulated earnings tax, personal holding company tax and professional service corporation tax are all examples of the complexity associated with operating in the corporate form, a complexity that is not present in the LLC.

These taxes also illustrate why the subchapter S election is so popular. This election avoids these three taxes. However, the subchapter S election is, itself, governed by complicated rules and restrictions. This helps explain why the LLC was developed. If the subchapter S election had been completely satisfactory, it is doubtful the LLC would have been created. Not having to avoid these taxes in the first place is an example of the simpler scheme of taxation associated with the LLC.

In addition, these taxes, and their complicated rules, also help explain why LLC owners normally do not elect to have their LLCs taxed as corporations.