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LLCs The Basic Tax Rules

 
 Written by: Steven J. Fromm, J.D., LL.M. (Taxation)
 
A limited liability company (LLC) is a business entity created under state law. Every state and the District of Columbia have LLC statutes that govern the formation and operation of LLCs.  Pennsylvania has its owns particular rules as to the legal and tax requirement of forming and operating an LLC.

The main advantage of an LLC is that in general its members are not personally liable for the debts of the business. Members of LLCs enjoy similar protections from personal liability for business obligations as shareholders in a corporation or limited partners in a limited partnership. Unlike the limited partnership form, which requires that there must be at least one general partner who is personally liable for all the debts of the business, no such requirement exists in an LLC.

A second significant advantage is the flexibility of an LLC to choose its federal tax treatment. Under IRS's "check-the-box" rules, an LLC can be taxed as a partnership, C corporation or S corporation for federal income tax purposes. This determination requires careful analysis as to what is the best choice for each particular client situation. 

In addition, a single-member LLC may elect to be disregarded for federal income tax purposes or taxed as an association (corporation).  If the disregarded entity is chosen, the individual can report the entities activity on his or her individual income tax return and need not file separate entity returns for the LLC.  However, some states and cities may require the disregarded entity LLC to file certain returns.

LLCs are typically used for entrepreneurial enterprises with small numbers of active participants, family and other closely held businesses, real estate investments, joint ventures, and investment partnerships. However, almost any business that is not contemplating an initial public offering (IPO) in the near future might consider using an LLC as its entity of choice.

Deciding to convert an LLC to a corporation later generally has no federal tax consequences. This is rarely the case when converting a corporation to an LLC. Therefore, when in doubt between forming an LLC or a corporation at the time a business in starting up, it is often wise to opt to form an LLC. As always, the possibility of a conversion in the future needs to be analyzed.

Another alternative from the tax side of planning is to utilize an S Corporation.  There are sometimes advantages to using this form of entity over an LLC.  In certain cases, a regular corporation, sometimes called a C corporation, may be advisable.  In certain situations, there may an issue as to where to incorporate. 

The choice of entity question along with the related federal, state and local tax implications is one that should be discussed with an experienced tax attorney BEFORE doing anything. In addition, proper documentation is critical when it comes to drafting of initial organizational documents, the operating agreement and members' (shareholders') agreements, etc.  Ongoing operations and annual compliance details should be kept in mind to insure that the entity chosen is respected as such so that personal assets are not put at risk due to any piercing of the corporate veil arguments. 

The bottom line here is that tax counsel should be part of the initial formation and ongoing operations of whatever entity chosen to insure protection against personal liability for business operations and to maximize the various tax advantages available depending on the entity chosen.

Copyright © 2010,2011 - Steven J. Fromm & Associates, P.C., 1420 Walnut Street, Suite 300, Philadelphia, PA 19102. All rights reserved.  

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