Advantages of an LLC Relative to a “C” Corporation
Tax Consequences to Owners. The primary advantage of the LLC over the “C” Corporation is in the tax consequences to owners. As a pass-through entity, the LLC’s income and losses flow through and are taxed to or deducted by the members, normally retaining the character they had in the LLC. Thus, there is a single level of tax, and losses are fully deductible by members (but are subject to passive activity rules and the deduction may not be in excess of their bases in their membership interests). The income of a C corporation is taxable, both by the federal government and your state, at the corporate tax rate. Thus the corporation and its shareholders may be subject to “double taxation”, when dividends are paid to shareholders because the corporation pays tax on its income and the shareholders pay tax on dividends received from the corporation, and the corporation is not allowed to deduct dividends as an expense.
Structure of the Owners Participation. The owners of the LLC have greater latitude and flexibility in providing for the return of an owner’s investment. There is also more liberty in structuring the owners participation in the enterprise.
Disadvantages of an LLC Relative to a “C” Corporation
Retention of Earnings. A venture that intends to retain substantial earnings may find the corporate structure beneficial. It is likely that the marginal corporate tax rate on the retained earnings (only 15% up to 50K) will be lower than the marginal rates applicable to individuals. One needs to carefully study the venture’s projections and calculate the estimated after-tax financial performance of the venture before making a decision.
Fringe Benefits. An LLC taxed as a partnership cannot provide many of the fringe benefits that a “C” Corporation can. Members are not “employees” for purposes of the fringe benefit rules. See, e.g., IRC 5105(9) relating to accident and health care plans and IRC #79 relating to group term life insurance. If the LLC provides members with fringe benefits, the cost must be included in the member’s gross income. In some states, “C”s can maintain more favorable asset-protected retirement plans.
Advantages of an LLC Relative to an “S” Corporation
Restrictions on Ownership. An “S” Corporation offers the advantage of limited liability for owners, and some of the advantages of being taxed as a partnership. It does not pay tax on its earnings, and its profits and losses are passed through and taxed directly to its shareholders. However, there are a number of restrictions on the ownership of and the operation of an “S” corporation that do not apply to an LLC. The “S” corporation can have only one class of stock. Its stockholders can be only natural persons, and those persons must be U.S. citizens or resident aliens. An “S” corporation may have no more than 75 shareholders.
Special Allocations. Further, an “S” Corporation may not specially allocate tax attributes to its shareholders. Those attributes pass through pro rata. This fact restricts the type of debt the corporation may issue, hampers efforts to gradually shift control of family-owned businesses, and in general makes passive investments difficult to structure.
Deductibility of Losses. An “S” corporation differs in the ability to obtain tax basis from its share of the entity’s liability, which determines the extent of losses that may be deducted by the owners, and their ability to receive operating distributions tax free. An “S” corporation shareholder does not share in the entity liabilities and its basis is limited to the cash invested. Both an LLC member and a limited partner increase their basis by the allocable share of entity liabilities. Moreover, distributions of appreciated property trigger a gain to the “S” corporation that passes through to the shareholders. Also, there is a second entity level tax on built-in gain, if the “S” corporation was formerly a “C”.
Disadvantages of an LLC Relative to an “S” Corporation
The LLC offers the limited liability of the “S” corporation and pass-through taxation with none of the “S” corporation restrictions on ownership and operations. Therefore, we really cannot see a great deal of general disadvantage. However, there may be some disadvantages in a special case.
Taxation of LLCs
One-owner LLCs are treated the same as sole proprietorships. Profits are reported on Schedule C as part of your individual 1040 tax return. Self-employment taxes on LLC net income must be paid just as you would with any self-employment business.
Multiple owner LLCs are treated as a partnership by the IRS. The tax return that the LLC completes and files is IRS Form 1065, Partnership Information Return. On this form, LLC profits are reported and allocated to each of the owners according to the LLC’s operating agreement. Each owner is given a Schedule K-1, which shows each owner’s share of LLC income or loss. The owner then reports and pays taxes on this income on the owner’s annual 1040 income tax return.
Please note that as with a sole proprietorship, all profits of the LLC are taxed to the owners, even if they are not actually distributed by the LLC. This situation could happen when the LLC needs to use its profits to meet ongoing expenses.
There is a possible third tax treatment that an LLC could elect if it did not want pass-through taxation. The LLC may elect to be taxed as a corporation by completing IRS Form 8832 and checking the corporate income tax treatment box. After making this election, the LLC is taxed as a C corporation by the federal government. Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to the taxable income of non-corporate taxpayers, it is possible a net income tax savings can result from this tax election.
The state income tax treatment of LLC profits typically mirrors the IRS tax treatment as discussed above. Some states have different rules and for specific information on your state rules visit your state’s web site.
Potential Major Discadvantages of Limited Liability Companies
In addition to any disadvantages of LLCs compared to other entities, one should keep in mind the following general drawbacks to the use of LLCs: The legal ramifications of forming and operating an LLC, e.g., tax classification is more uncertain because of the lack of guidance from established case law and regulations. This may be more theoretical than real. Other states may not recognize all of the rights and privileges afforded to an LLC in your home state. If the LLC has one or more members who are non-residents of the LLC state, it must file a list of members and consents with its annual state tax return. As to any non-resident member who fails to consent to Your state tax jurisdiction, the LLC must pay the tax attributable to the non-consenting member’s distributive share of LLC income. The members of an LLC may have implied authority to act on behalf of the LLC and bind the LLC, e.g. signing of deed of trust (mortgage).
As a general rule, the LLC will probably serve well in those circumstances where the limited partnership and “S” corporation were formerly used. The LLC may even be used in those circumstances where the “C” corporation was used. However, the “C” corporation does have its advantages, particularly with respect to the availability of nontaxable fringe benefits and asset protected retirement plans. Therefore, we recommend you continue to use the “C” corporation in those circumstances where a “C” corporation was formerly used. Use an LLC in those situations were a limited partnership (including an FLP, unless a specific estate and gift tax result is desired) or “S” corporation was formerly used.