LLC Series Part 1 – The Chameleon: Legal Form vs. Tax Classification
In 1977 Wyoming pioneered the first-ever Limited Liability Company act. What began as an obscure new type of business entity has become the dominant form of business entity across the U.S. with LLC laws on the books of every state. LLCs have far surpassed corporations and partnerships because they’re relatively easy to form, they don’t require the same level of corporate formality that other entities need, they limit owners’ liability, and they’re “tax chameleons.”
But poorly formed and carelessly managed LLCs provide little or no benefit to the business owner. In this multi-part series we’ll discuss some of the finer points of using LLCs in business and estate planning with the hope that readers develop a better understanding of how LLCs work, and how to get the most from LLC planning.
Understanding a Company’s “Legal Form” versus its “Tax Classification”
Many business owners don’t fully understand the difference between the legal form of a company and the way the IRS taxes the business. For example, a partnership formed under state law is always taxed as a partnership under the tax code. A corporation formed under state law can either be taxed as a subchapter C corporation (a “C corp”) or as a subchapter S corporation (an “S corp”). A limited liability company formed under state law is a tax chameleon: it can be taxed however the owner wants it to be taxed. Before we get to an explanation of LLCs specifically, we should take a diversion to lay a little groundwork on other forms of business entities.
Different Types of Partnerships
Partnerships themselves take many different “sub-forms,” each of which is defined by state law. But in each instance they are taxed as a partnership under tax laws. The various sub-forms include:
- General Partnerships (GP) – where each partner has full management responsibility and full liability for partnership activity;
- Limited Partnerships (LP) – where a general partner manages the operations and is personally liable for partnership activity, and one or more limited partners have ownership interests but cannot manage the company and have no personal liability for partnership activity;
- Limited Liability Partnerships (LLP) – where all partners may actively be involved in management, but with limited liability;
- Limited Liability Limited Partnerships (LLLP) – where the general partner(s) manage the partnership but have limited liability, and where one or more limited partners have purely financial interests (no management authority).
Corporations: Subchapter C and Subchapter S
A corporation formed under state law can either be taxed as separate taxpayer (C corporations), or as a “pass-through” company (S corporations). The key difference between these is that a C corporation itself is first taxed on corporate earnings at the corporate income tax rate. Amounts distributed to shareholders are taxed again as individual income when the shareholders file their individual income tax returns. This is referred to as the “double taxation” of corporate income. C corporations are popular for many larger enterprises because they can issue different classes of stock, which have different economic rights.
By contrast, an S corporation does not pay income tax at the company level. All tax liability “passes-through” to the shareholders as they report taxes individually, similar to how a partnership is taxed. S corporations can only have one class of stock; all shareholders have the same economic rights based on the number of shares they hold. (Note that S corps may have different levels of voting rights.)
Limited Liability Companies
A limited liability company is simply a legal form of business entity created under state law; it does not describe how the company is taxed. Under the law LLCs are tax chameleons – they can be taxed any way the owner chooses: as a C corporation, an S corporation, a partnership, or for single-owner LLCs, as a sole proprietorship. As a result, LLCs are the most flexible form of company from a tax perspective.
The following table may better illustrate these differences.
|Legal entity type||Notes||Income tax treatment|
|Partnership||Requires more than one owner. (You can’t be a “partner” with yourself.) Ownership is represented by partnership interests, usually as a fraction or percentage of the partnership and recorded on the partnership’s books.||No income tax at the entity level. All tax items “pass through” as individual income to the partners according to the partnership’s ownership structure or partnership agreement.|
|Corporation||Corporations issue shares of stock, usually in the form of a stock certificate.
Subchapter C Corporations may issue multiple classes of stock, often referred to as “common” and “preferred” stock.
Subchapter S Corporations can only have one class of stock (“common” and “preferred” stock is not permitted), but may have voting and nonvoting stock within the same class. There are also restrictions on the number and type of permitted shareholders in an S-corp.
|C-corps are taxed on income at the corporate level as a separate taxpayer. When a C-corp distributes income to shareholders the income is taxed again as the shareholders report distributions on their individual income tax returns. (This is referred to as “double taxation” of corporate income.
S-corps are similar to partnerships in that the tax items “pass through” to the shareholders and are not taxed at the corporate level. All income is taxed at the individual shareholder’s own tax rate.
|Limited Liability Company||May be owned by a single member (simply called a single-member LLC, or SMLLC) or by multiple members (a MMLLC).
Ownership is represented by “membership interests,” which may be in the form of a fraction or percentage of total LLC equity, or less commonly, as certificates of set numbers of membership interests (similar to stock).
|A single-member LLC (SMLLC) may be taxed as a sole proprietorship (the default option) or it may elect to be taxed like an S corporation or a C corporation.
A multi-member LLC (MMLLC) may be taxed as a partnership (the default option) or it may elect to be taxed like an S corporation or a C corporation.
There are many factors that go into determining what legal form of entity makes the most sense for a new business, whether that business is an active trade or business, a holding company for managing rental real estate, etc. If an LLC is chosen as the legal form, the next question centers on how to structure the tax treatment of that LLC. Individuals interested in forming LLCs for any purpose should work closely with an experienced attorney to design the LLC and its governing documents, and with a good accountant to help advise on the most strategic form of tax treatment.
In the next part of this series we will explore different options available under state law, with an eye toward understanding how different states’ laws provide differing levels of flexibility and protection. If you have any questions or comments about this article, or to schedule a consultation, please contact us to discuss how LLC planning may work in your situation.