East Carolina University

Limited Liability Company

Taxed, Tax Free, or Both?

David Hatfield
ACCT 4611
Dr. Joseph Hagan
November 17th, 2015

Table Of Contents
I.
II.
III.
IV.
V.

Introduction
What is a Limited Liability Company?
Limited Liability Company vs. Corporation
Subchapter S Corporation Comparison

Pg. 1
Pg. 1
Pg. 2
Pg. 4

Conclusion

Pg. 5

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Introduction
Limited Liability Company, a better entity choice than the rest? One of the most
important strategy decisions a business can make is determining what type of entity to classify its
self as. This choice decides not only how the company will run day-to-day operations but also
has a significant impact on the tax structure the business will have. The purpose of this paper is
to relate the tax features and principles of a limited liability company to other relevant business
entities.
What is a Limited Liability Company?
A limited liability company (LLC) is a business entity with a broad scope of features. A
limited liability company is a business entity allowed by state laws and can be simply defined as
an unincorporated legal entity owned by one or more members. Limited liability companies
combine the best qualities of corporations and partnerships into a single entity. The IRS describes
the owners of an LLC as members, and that most states permit single-member LLCs, or one
with a single owner. The main advantages that can be received by an LLC are the taxation
benefits similar to partnerships and the limited liability similar to corporations.
The taxation of a limited liability company is a decision left to the members. A LLC, for
tax purposes, can be treated as a corporation, partnership, or as a disregarded entity (LLC with
only one owner). More specifically described by the IRS, a domestic LLC with at least two
members is classified as a partnership for federal income tax purposes unless it files Form 8832
and affirmatively elects to be treated as a corporation.1 Limited liability companies have the
option to be treated as a corporation, but there is no significant reason why a LLC would elect to
be treated as a corporation for tax purposes, it simply goes against the original purpose of
creating an LLC. Most businesses elect for their taxation to be treated as a partnership, which is

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also the default option unless otherwise stated. The taxation advantage of a partnership is the
pass-through taxation of income. Meaning the income generated by a partnership is not subject
to taxation at the entity level, instead the income is reported on each individuals return as taxable
income.
LLCs have limitations themselves in order to maintain their status the structure cannot
include more than two legal characteristics of a corporation. These characteristics include limited
liability, continuity of life, free transferability of equity interest, and centralized management.
Most organizations are more likely to choose limited liability for its members and centralized
management. Centralized management provides for more flexibility with the companys
structure and how the business can be operated. The limited liability of a corporation applied to
an LLC limits the individual members liability to the amount of debt that each assumed. This
allows members to only assume the risk they are willing to handle. The complication with
members assuming limited liability is that creditors may refuse to lend the company money
unless the members can personally guarantee the debt, collateral is offered in place of the debt or
the bank deems the company credit worthy. Limited liability for owners of a business would be
one of the main reasons a business would elect to form an LLC. If an LLC decides to choose
limited liability and centralization of management, then the company must be limited from
having continuity of life, and free transferability of interest.
Limited Liability Company vs. Corporation
A limited liability company shares similar attributes of a corporation while avoiding some
restrictions a corporation can have. LLCs for tax purposes are a non-taxable entity under
subchapter K of the Internal Revenue Code the income flows through to the LLCs members. For
federal income tax purposes, a C corporation is recognized as a separate taxpaying entity.2

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Corporations face a disadvantage with taxation of income, called double taxation. The double
taxation arises when the corporation pays its stockholders in the form of dividends. A corporation
is not able to deduct dividends from its taxable income and stockholders must include dividends
as income on their income tax returns. Thus, the income earned by the corporation and then
returned to the stockholders is levied by taxes twice. Limited liability companies do not face this
issue of double taxation. The income earned by the company is not taxed on the entity level.
Income is passed through directly to the members of the company, to which it is taxed on the
individual level.
The IRS mentions that some businesses generally cannot be limited liability companies,
such as banks and insurance companies. A reason the federal government would not allow banks
and insurance companies the option to become a limited liability company is that these types of
institutions make a lot of money. The federal government earns a lot of revenue from the double
taxation of these institutions as corporations. Having flow through of income to owners is
illogical and could cost the federal and state governments fortunes in lost tax revenue.
Another significant difference between a limited liability company and a corporation is
the allocation and treatment of income and operating losses. The net income and various
deductions and tax credits from the LLC are passed through to the members based on their
respective percentage interest in the profits and losses of the company, and the members include
the income and deductions in their individual tax returns.3 Meaning, a member of an LLC
recognizing their share of the companys operating income, deductions, and tax credits in their
calculation of income. The details of these amounts specific to each member is located on
Schedule K-1. The member is required to pay tax on the income generated by the business,
calculated on Schedule K-1. It also represents an owners portion of the items located on

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Schedule K Form 1120S. If the company records an operating loss for the year then the partner is
also able to receive the immediate benefit of recognizing their share of that loss, which reduces
that partners taxable income. The ownership of a corporation is divided into shares, thus any
income from the corporation is shared equally amongst all shareholders, but operating losses
cannot be passed through directly to them. A corporation is allowed to carry-back any net
operating losses for the two prior years, and carry-forward any remaining losses for the
following twenty years.4 Advantageous, yet if a corporation is new or has not yet been profitable,
operating losses provide no immediate benefit to a corporation or its owners, compared to the tax
effects that losses have on partnerships.
Subchapter S Corporation Comparison
The subchapter S corporation is a business entity that meets a LLC and a corporation in
the middle with regards to its regulations and similarities. An S corporation assumes the limited
liability similar to both a limited liability company and to a C corporation. A creditor to an S
corporation can only attempt to receive the debts of the corporations from an individual owner
up to the amount that the owner invested. A major advantage to an S corporation, and similarity
to a limited liability company, is the pass through of income and losses to shareholders personal
tax returns. This key element of an S corporation, means the entity and shareholders avoid
double taxation of the income generated. Also the tax rate implied to the income is the
individuals income tax rate, not the tax rate for a corporations income, and the shareholders pay
the tax not the corporation. In comparison with the limited liability company, the S corporation
could be a suitable replacement if conditions are available. A difference between the S
corporation and a limited liability company is the missing flexibility in allocation of income to
the percent interest a partner has. The S corporation has shareholders, and all allocations of

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income and loss are allocated to the shareholders by percent ownership of stock. An S
corporations also has set requirements to be able to qualify, some of those requirements being a
domestic corporation, have allowable shareholders, have no more than 100 shareholders, have
only one class of stock, and it must not be an ineligible corporation. To qualify as an allowable
shareholder, only individuals, estates, and certain trusts may be shareholders, and a shareholder
may not be a partnership, corporation, or non-resident alien, these qualifications are not present
for becoming a limited liability company. An ineligible corporation would be a financial
institution or insurance company, similar restrictions to that of a limited liability company. A
requirement that for an S corporation that sets a part the other two discussed entities is the limit
to 100 shareholders. Limited liability companies have no clear restriction on the amount of
partners it may have, and neither does a corporation.
Conclusion
A limited liability company can provide many features and taxation options to a business that
other business entity may not be able to provide. There are many advantages to classifying a
business as a limited liability company. Owners of the company receive limited liability towards
their investment, and receive protection of their personal assets. They receive this limited
liability while avoiding double taxation that is placed on C corporations. Limited liability
companies offer flexibility to creating a businesses structure. One of the best advantages that
arise from forming a limited liability company is the pass through of the companys income and
loss directly to the owners income tax return. Choosing the correct business entity relies on a
firms business structure and strategy, and choosing a limited liability company if the structure
fits seems like a good strategy.

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Bibliography
Jones, Sally; Shelley Rhoades-Catanach (2015-03-27). Principles of Taxation for Business and
Investment Planning. McGraw-Hill Higher Education. Kindle Edition.
Meger, Cheryl; How to Help Clients Pick the Best Entity for Their Business; August 31, 2015;
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Liability Companies: Best of both worlds?; Article
1. Treas. Reg. 301.7701-2(a); Morrissey v. Commissioner, 296 U.S. 344 (1935).
2. See income tax rate discussion, notes 27 and 28.
3. Limited Liability Companies: The Entity of Choice in Missouri, National
Business Institute, Inc.'s audio tape series (Jan. 2021, 1994).
4. Price, at 49.
5. See Ill. P.A. 1062, 1-25 (1992).
6. I.R.C. 311 (a) and (b).
7. I.R.C. 336.
8. Horwood, at 355.
9. I.R.C. 752.
10. 29 Senator Danforth proposed liberalization of S restrictions in 1993-94, but
passage is doubtful.
11. .R.C. 1361 to -1380.
12. I.R.C. 1361.
13. I.R.C. 1361.
14. Section 7704; see Notice 88-75, 1988-2 C.B. 386 and Harris, at 226.
15. Porter, at 277.
16. I.R.C. 1361.
1. https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Corporations
2. https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Limited-LiabilityCompany-LLC
3. http://smallbusiness.chron.com/limited-liability-company-advantages-disadvantages4369.html
4. https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations
5. American Bar Association, Family Legal Guide, 3rd ed. (New York: Random House
Reference, 2004).
6. IRS Publication 563
7. IRS Publication 541

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