Tax implications are one of the many factors that go into determining what choice of entity a business should become during the corporate formation stage of its development. In deciding whether to become a limited liability company (LLC), entrepreneurs need to weigh the tax advantages and disadvantages, along with other protections afforded to LLC’s, in understanding whether or not an LLC is the correct choice of entity for their venture. This article is going to explain how becoming an LLC will affect the company’s status for federal tax purposes.
In 1994 the State of Washington passed the Washington Limited Liability Company Act (the "Act") which allowed the State to pass a variety of laws to form LLC’s (RCW 25.15). The primary non-tax benefit of LLC’s is the limited liability protection afforded to its members, or, in other words, no member of the LLC will be personally liable for the LLC’s obligations in excess of the amount that he or she contributed, or is otherwise obligated to contribute, to the LLC. From a State tax perspective, LLC’s are entities just as distinct as corporations, general partnerships, or limited liability partnerships (to name a few).
However, federal tax law treats LLC’s totally different than the way state tax law does. The status as an LLC, under state law, is not determinative of its treatment for federal income tax purposes. Such treatment is determined under the separate federal income tax rules. These rules have evolved over the years from a "Four Factor Test" to a "Check-the-Box Regulation". The Four Factor Test was done away with, mostly because it caused uncertainty and confusion as to the proper tax treatment of an entity.
The Check-the-Box Regulation was adopted in 1996 by the Treasury Department under Section 7701 of the Internal Revenue Code of 1986 (IRC). These regulations were used to simplify the tax classification and afford flexibility in the tax treatment of LLC’s. Generally, an LLC has a choice as to what type of tax classification it can choose, which all depends on whether the LLC is a single-member or multi-member LLC.
Single-Member LLC
A single-member LLC may elect to be treated as either a disregarded entity or as a corporation for federal income purposes. The default treatment for a single-member LLC is as a disregarded entity, but if the LLC wanted to be classified as a corporation, then it must file a Form 8832 with the IRS within 75 days of the formation of the LLC. If the LLC accepts the default treatment as a disregarded entity, then the Form 8832 does not need to be filed. However, if the LLC wants to be classified as a corporation, then it must either choose to be taxed as a "C" corporation or as an "S" corporation.
Multi-Member LLC
Multi-member LLC’s may elect to be treated as either a partnership or as a corporation. The election, as a corporation, is made by filing a Form 8832 with the IRS within 2 months and 15 days of the formation of the LLC. Otherwise, the default treatment for multi-member LLC’s is as a partnership, and of course, if the default treatment is accepted, no Form 8832 is needed to be filed with the IRS. If the multi-member LLC elects to be treated as a corporation, then it has the choice of being taxed as a "C" or "S" corporation by filing a Form 2553.
If the LLC is treated as a partnership, then it is not taxed at the LLC level, but instead is a pass-through entity such that its income is taxed to its members. However, the LLC must file a partnership income tax return. If the LLC is being treated as a corporation, then it will be treated as a C corporation for federal income tax purposes, unless the LLC makes a further election to be treated as a S corporation by filing a Form 2552 with the IRS. An S corporation is a pass-through entity that the tax treatment of which is similar to a partnership.
The following are tax factors that may implicate whether or not one should choose an LLC as their corporate entity status: double taxation, contributions and distributions of appreciated property, deduction of losses, phantom income, eligibility for pass-through treatment, special allocations, medicare taxes, inclusion of debt in basis, tax returns, tax year, accumulation of earnings, and state tax considerations. Only solid legal and tax professionals will be able to fully help entrepreneurs understand whether or not being an LLC is right for them. So contact an attorney to discuss this and other important issues as your business venture begins to takeoff.