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 single-owner 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, all of the states have now 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 pro-rata 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 75 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.