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 with more than one member is treated identically to a partnership and it must file a Form 1065, U.S. Partnership Return of Income, unless it elects to be taxed as a corporation. An LLC with only a single member is taxed as a sole proprietorships, whose owners must simply file a Schedule C with their Form 1040, unless the LLC elects to be taxed as a corporation.

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, every state has enacted legislation providing for limited liability companies. 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 100 shareholders.

Other factors to consider. There are a number of nontax factors, such as protecting your assets from creditors, that may influence your decision as to whether a LLC is the right form of business for you. We recommend that you seek legal advice in setting up a LLC and writing up the operating agreement.