Taxation of California Limited Liability Companies

The limited liability company (“LLC”) is a relatively new type of entity which is now available in almost every state in the U.S., including California. It has a combination of features which is not found in any of the other available business forms.

The LLC is very desirable for situations in which the California business owners wish to have partnership-type flow-through tax treatment, along with protection from personal liability. These are the same features which attract business owners to the S corporation, but the S corporation form has many limitations which restrict its use. Many California based businesses which would like to use the S corporation form are not eligible for S corporation status. In addition, the S corporation rules have many prohibitions and conditions which make it less attractive, even when it is an option.

Since corporations and non-resident aliens cannot be shareholders of an S corporation, the S corporation structure is not an option for enterprises owned by foreigners or for joint ventures involving corporations.

The desirable flow-through tax treatment (passing the tax consequences of losses, investment tax credits, and depreciation through to the individual owners) is regarded as “partnership” tax treatment, as opposed to “corporate” tax treatment. The tax return of the organization – the S corporation or LLC – shows the profits and losses, but the tax consequences of that informational return are prorated among the shareholders (or “members” in an LLC).

The key benefits of this flow-through of tax consequences are that profits and gains are taxed only once and taxed at the tax rate of each shareholder or member.

The tax treatment of LLCs can be more fully described as follows:

Until recently, in order to obtain the partnership tax treatment for federal tax purposes, an LLC had to be structured so that it did not have too many corporate features. If the entity had more than two corporate features, it would be taxed as a corporation.

Now the IRS and the state of California have both adopted a “check the box” system of allowing entities to select the type of tax treatment they wish to be subject to. As a result, it is no longer necessary for federal or California tax purposes to limit the number of corporate features an LLC has.

However, an LLC subject to tax in states which still look to the features of the LLC to determine whether it is subject to tax as a corporation or as a partnership, must still meet the tests in those states in order to obtain the desired flow-through tax treatment.

The old rule, which may affect taxation in some states, would require that an LLC have no more than two of the following four corporate characteristics in order to receive partnership tax treatment:

1. limited liability 2. continuity of life 3. centralization of management
4. free transferability of interests

Since the LLC form is usually desired in order to provide the participants with limited liability, it is two of the other three corporate characteristics which are usually given up in structuring an LLC in order to qualify for state partnership tax treatment.

If S corporations and LLCs are taxed as partnerships, are there tax differences between the two forms? Yes, there are differences, but they may or may not be significant to a particular business, since that depends upon the tax circumstances of the business.

Unlike the shareholders in an S corporation, but like partners in a partnership, the LLC members get to treat their share of all LLC liabilities as part of their tax basis. In an S corporation, a shareholder may only increase his or her tax basis by such entity debt if that shareholder is personally liable for the debt.

In addition, an LLC is permitted to allocate income, gain, loss, and deduction items among the members, provided such special allocations comply with applicable tax rules. S corporations are prohibited from making such special allocations because special allocations are considered a second class of stock, which is prohibited under the S corporation rules.

LLC tax treatment is better than S corporation tax treatment in other ways. LLCs are not subject to the built-in gains tax or tax on excessive passive income that can apply to S corporations. S corporations which converted from C corporation status with certain tax circumstances are subject to built-in gains taxes on gains existing prior to the conversion and on passive income in excess of 25% of gross income.

Another difference that may not be meaningful to all businesses, is that the conversion from an LLC to another legal form of entity such as a corporation is not subject to tax. Just as a partnership may be converted into a corporation without triggering taxes on capital gains or causing other taxable events, the LLC may also be converted into a corporation. If, instead, a corporation wishes to convert into an LLC, the corporation must first liquidate, subjecting both the corporation and the shareholders to potential taxes.

Consult with a qualified business and tax attorney like Mitchell A. Port at (310) 559-5259 for further information.