Tax Aspects of Limited Liability Companies The limited liability company (LLC) is a hybrid of a corporation and a limited partnership

that is created under state law. For federal tax purposes, an LLC is treated 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 singleowner LLCs, which are treated identically to sole proprietorships and whose owners must simply file a Schedule C with their Form 1040.) Under state laws, LLC owners are given the protection from liability that was previously afforded only to corporate stockholders. Although the LLC is a relatively new business form, every state has enacted legislation providing for limited liability companies. Formerly, the IRS had treated limited liability companies as partnerships rather than as corporations only if the business did not possess more than two of four characteristics of corporations: centralized management, continuity of life, free transferability of interests, and limited liability. Under regulations that went into effect at the start of 1997, newly formed LLCs can obtain partnership tax treatment even if they have all four corporate characteristics; in fact an LLC will be presumed to have partnership treatment unless it elects to be treated as a corporation. However, while LLCs are treated as partnerships for federal tax purposes, the same is not always true for state tax purposes. You'll need to check your state tax laws. Comparison with S corporations. While S corporations also provide limited liability for their owners and favorable pass-through tax treatment, LLCs do provide some additional advantages to growing businesses. Like a partnership, an LLC has the ability to make disproportionate distributions to its owners (for example, a LLC member may have a 50 percent ownership interest in LLC assets but be entitled to 60 percent of the income, if the operating agreement so provides). In contrast, S corporations must generally make all distributions prorata in accordance with the number of shares held by each owner. An LLC can have an unlimited number of investors, whereas an S corporation is limited to 100 shareholders. Other factors to consider. There are a number of nontax factors that may influence your decision as to whether a LLC is the right form of business for you, and we recommend that you seek legal advice in setting up a LLC and writing up the operating agreement. Businesses that are engaged in operations that are considered "risky" or subject to frequent lawsuits are often encouraged by their legal advisors to incorporate. Moreover, the corporate structure can make it much easier to obtain investment capital and to pass the business down to the owner's children or other successors upon death or retirement.

From a tax perspective, there are two options for corporations under federal income tax law: C corporations are what we normally consider "regular" corporations that are subject to the corporate income tax. S corporations are corporations that have filed a special election with the IRS. 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 of nontax factors that may influence your decision as to whether a corporation is the right form of business for you, and we recommend that you seek expert legal advice in setting up a corporation and writing up the articles of incorporation. C Corporation Taxes A regular corporation (also known as a C corporation) is taxed as a separate entity. Income earned by a corporation is normally taxed at the corporate level using the corporate income tax rates shown in the table below, and the corporation must file a Form 1120 each year to report this income. After the corporate income tax is paid on the business income, any distributions made to stockholders are taxed again at the stockholders' tax rates as dividends. Because of these two levels of tax, a regular corporation may be a less desirable form of business than the other business entities (sole proprietorships, partnerships, limited liability companies, or S corporations). Comparison with partnerships or sole proprietorships. Because the taxation of income to sole proprietorships and partnerships is determined by the tax bracket that applies to each individual owner, a comparison of tax rates that apply to corporations and to individuals can give you some idea of which form of business would save taxes at a particular income level. The following chart compares the marginal tax rates for tax years beginning in 2009 for corporations, married individuals filing jointly, and for singles. Taxable Income ($) 1-8,350 8,351-16,700 16,701-33,950 33,951-50,000 50,001-67,900 67,901-75,000 75,001-82,250 C Corp. Married/Joint Individual 15% 15% 15% 15% 25% 25% 34% 10% 10% 15% 15% 15% 25% 25% 10% 15% 15% 25% 25% 25% 25%

82,251-100,000 100,001-137,050 137,051-171,550 171,551-208,850 208,851-335,000 335,001-372,950 372,951-10,000,000 10,000,001-15,000,000 15,000,001-18,333,333 Over 18,333,333

34% 39% 39% 39% 39% 34% 34% 35% 38% 35%

25% 25% 28% 28% 33% 33% 35% 35% 35% 35%

28% 28% 28% 33% 33% 33% 35% 35% 35% 35%

Note: personal service corporations (those whose employees spend at least 95 percent of their time in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) are taxed at a flat rate of 35 percent of net profits. As the table shows, corporations generally have the same or a higher tax rate imposed on their income compared to those subject to individual tax rates. Also keep in mind that the rate comparison is only part of the tax picture to consider: distributions (money taken out) from a partnership are generally taxable only once on the partners' individual returns, while distributions made by a corporation to its shareholders after corporate tax is paid are taxed again as dividends on the shareholder's returns. Salaries may offset corporate income tax. In comparing the tax advantages of operating as a partnership or sole proprietorship rather than as a corporation, remember that not all of the corporate profits will be subject to double taxation. The operators of the corporation may withdraw reasonable salaries, which are deductible by the corporation. These salaries are therefore free from tax at the corporate level (though the recipients will have to pay income tax, and both recipients and the business will have to pay FICA tax, on them). In some cases, the entire net profit may be offset by salaries to the owners, so that no corporate income tax is due. Accumulated earnings tax. Because a corporation is a taxable entity that is separate from its stockholders, its excess profits (profits remaining after being taxed at the corporate level) are not, as in the case of unincorporated businesses and S corporations, taxed to the owners when they are earned. The profits are taxed only if and when they are distributed to the stockholders as dividends. However, a corporation may not safely accumulate (retain) its earnings indefinitely. If the accumulations are not related to the reasonable needs of the business, an accumulated earnings tax of 15 percent will apply (the rate of the tax used to be the highest individual income tax rate prior to enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003) in

addition to the regular corporate tax. Virtually any corporation can accumulate up to $250,000 in retained earnings without becoming subject to this tax. Transactions between corporations and owners. Transactions between a closely held corporation and its stockholder-owners will be closely examined by IRS agents. If corporate property is diverted to the stockholders, they will be considered to have received what is called a "constructive" or "preferential" dividend. This tax treatment is highly unfavorable, since this dividend will be taxable to the owners and will not be deductible to the corporation. The most common type of preferential dividend received by stockholders involves the payment of personal expenses on behalf of stockholders. Typically, the corporation claims deductions for these expenses as business expenses on its income tax return, but where the expenses are clearly personal expenses, the corporation will be denied a deduction and the officer-stockholder will be deemed to have received a taxable dividend. Stockholders are also considered to have received constructive dividends when: (1) corporate property is sold to a stockholder at less than its fair market value, (2) employee-stockholders are given unreasonably high compensation, (3) the corporation pays excess rents to shareholders for property leased by the corporation, or (4) the corporation loans the shareholder funds and there is no intention to repay the loan. Corporate Alternative Minimum Tax. Like individuals, corporations can become subject to an Alternative Minimum Tax (AMT) if they have gained the benefit of "too many" tax preference items. As of 2009, the corporate AMT will not apply to any corporation if (1) the corporation is in its first year of existence or (2) the corporation was treated as a small corporation exempt from AMT for all prior tax years after 1997 and its average annual gross receipts for the last three years ending before the 2009 tax year did not exceed $7.5 million ($5 million if it only existed for one prior year). For corporations that are subject to AMT, the general rate is 20 percent (the rate is reduced to 15 percent for certain specific items). S Corporation Taxes An S corporation is a creature of the federal tax laws. For all other purposes, it's treated as a regular corporation. So, to form an S corporation you first have to incorporate under state law. Then, you must file a special IRS form electing to be taxed similarly to a partnership. This election preserves the corporation's limited liability under state law but avoids taxation at the corporate level. This means that income and losses of the S corporation are passed through to shareholders in much the same 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 be allocated according to each shareholder's proportionate shares of stock; so, if

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 one partner or member can receive different percentages (or changing percentages over time) of different tax items if the operating agreement so specifies. S corporation requirements. Although the tax laws don't limit S corporation status to small corporations in terms of revenue, the requirements for electing can make it difficult to operate a large business as an S corporation. To obtain S corporation status under the federal income tax law, all of the following requirements must be met: The corporation must be a domestic corporation (a corporation organized under the laws of the United States, a state, or territory that is taxed as a corporation 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 alien or nonhuman entity (such as other corporations or partnerships), unless the shareholder is an estate or trust that is authorized to be an S corporation shareholder under the tax laws. Certain exempt organizations, such as qualified pension, profit-sharing, and stock bonus plans, or charitable organizations will be allowed to be shareholders in an S corporation (for purposes of determining the number of shareholders of an S corporation, a qualified tax-exempt shareholder counts as one shareholder). Prior to 1997, an S corporations could not have subsidiaries, and could not be a member of an affiliated group of corporations. As of 1997, an S corporation can hold qualifying wholly owned subsidiaries and can own 80 percent or more of the stock of a C corporation. The C corporation subsidiary can elect to join in the filing of a consolidated return with its affiliated C corporations, but the S corporation cannot join in the election.