Tax Implications of the Limited Liability Company
by William Bronchick, Esq.

The limited liability company has created some confusion and uncertainty for entrepreneurs considering their choice of entity for doing business. Initially, most legal and tax practitioners were concerned about how the LLC would be treated by the IRS for tax purposes.

In the past, the Internal Revenue Service used a four-part test to determine if an entity should be treated as a corporation for income tax purposes. Remember, the U.S. Constitution makes Federal law (income taxation) supreme to state law (definition of entity). The 4 part test was:

Is there centralized management?
Does the entity have perpetual life?
Is there free transferability of ownership?
Is there limited liability?

If more than two of the four factors existed, the IRS could re-classify an entity as a corporation for tax purposes. This could be devastating if you are filing as a partnership and were reclassified as a "C" corporation (double taxation). The IRS abandoned this approach in favor of a more simple formula:

If the entity is not a corporation and has two or more associates, it is a partnership
If the entity is not a corporation and has only one associate, it is ?disregarded.?

Thus an LLC with two or more members (owners) will file as a partnership, using IRS form 1065. LLCs with one member are treated as "non-entities," i.e., the member reports as if the LLC did not exist.

Example. John Doe forms a single member LLC under Delaware state law to sell widgets. He reports on Schedule C of his Federal tax return.

Example. Mary Roe has two rental properties and forms an LLC to hold title. She continues to report on Schedule E.

"S" CORPORATION MAY STILL BE THE BETTER CHOICE FOR THE SELF-EMPLOYED

As you may know, a self-employed sole-proprietor pays self employment tax on his income (approx 15% of the first $60,000). The proprietor who forms a single member LLC still files on Schedule ?C?and still pays SE tax. Forming an S corporation may avoid some self employment tax. In an S corporation, only salary is subject to SE tax. Corporate dividends are not subject to SE tax.

Example. John Doe makes $50,000 in net income and pays approx $7500 in SE tax. By forming an S corporation, he can take $25,000 of the profit in salary (subject to SE tax) and $25,000 in dividend (not subject to SE tax). This assumes, of course, that John can justify to the IRS that he can hire an employee in the marketplace for $25,000 to do the same job.

TWO CHOICES FOR THE "FAMILY" LLC

An LLC formed between husband and wife has a choice for filing. Since a husband and wife business can normally report as a partnership or sole proprietor, they have the same choices with an LLC. Thus a husband and wife LLC can choose to file a 1065(partnership return) or simply report on Schedule ?C?.

WHAT ABOUT PARTNERSHIP INCOME?

Partnership income is treated for self employment tax purposes according to how it is earned. For example, rental income is generally a passive activity, not subject to SE tax. A general partner?s income, which is earned by actively participating in a business, is subject to SE tax (the IRS has some complex formulas for calculating the number of hours worked, etc., which you can review individually with your CPA or tax advisor).

If you are forming an entity to buy and hold rental property, an LLC filing as partnership is a safe bet (no SE tax). However, if you are buying and "flipping" real estate, your activity may be considered "active" and subject to SE tax. Consider using a corporation rather than an LLC for this purpose to limit your SE tax liability as described above.