Taxation Of Llcs

THE TAXATION OF LIMITED LIABILITY COMPANY (LLC)

I. INTRODUCTION

Traditionally, businesses are categorized any of the three forms of organization: sole proprietorship, partnership, and corporation. Since the economic environment evolves through the passage of time, the organizational forms that play vital roles in the business playfield was not exempted from this change. In a taxation point of view for instance, corporations are divided into C type and S type. National taxation laws offer different advantages and disadvantages for these entities. As such, many other business organizational forms developed such as limited liability partnerships (LLP), professional limited liability partnerships (PLLP), and the subject of this paper, limited liability company (LLC).

An LLC is defined as an unincorporated company formed under applicable state statute whose members cannot be held liable for the acts, debts, or obligations of the company and that may elect to be taxed as a partnership. According to Humphreys, LLC's are destined to be the common choice of entity for private business and investment enterprises. It possesses the foremost features of both partnership and corporation, and thus, considered as a hybrid version of both. The choice is swayed by LLC's numerous advantages if seen in different viewpoints.

In terms of owners' liability, it enjoys protection like that of a corporation. Creditor claims would be limited to what the LLC possesses and does not extend to the personal assets of owners (which are called "members"). Exception to this advantage is when a member signed a personal guarantee or engaged in wrongful conduct meant to defraud the LLC or its clients or customers, in which case the court may "pierce the corporate veil." In the viewpoint of organization, the tenets imposed on LLC's are less complex than that of most states impose on forming corporations. Examples of these are the waiving of requirements for annual meetings of members and bylaws. However, to provide and maintain proper governance, members are more likely to adopt an Operating Agreement or Limited Liability Company Agreement.

II. PASS-THROUGH TAXATION

As far as the Internal Revenue Code is concerned, an LLC is taxable as a partnership . As such, it also inherits the partnership's pass-through tax mechanism and advantage. For the purpose of arriving at the net income or loss, an LLC is considered as a separate entity, distinct from its members. By using a definite accounting method, the LLC computes its operational result for a given year, and elects tax treatments of amount and timing of income recognition and deduction at the entity level. Eventually, the income, losses, gains, deductions, and credits pass from the LLC to its members, without being taxed at the LLC level, unlike the corporate set up that shoulders an income tax rate of either 15%, 25%, or 34% on corporate net income and another round of taxes when distributed to shareholders as a dividend. Whether actually or constructively received, the share in income and loss of operations in an LLC are reported in each member's individual income tax returns. Therefore, in terms of reporting and paying income tax, an LLC is viewed as a cluster of individuals rather than as a separate entity.

The character of an income or loss item for an LLC will be the same for its members. This feature made accounting of distributive share easy for the members as set by the LLC's Operating Agreement or Limited Liability Company Agreement. In case where the Operating Agreement does not provide the distribution ratio or any other method of allocation or that the allocation provided has no substantial economic effect, distributive share will be dictated by the members' interest in the LLC. Moreover, income, gain, loss, and deductions in relation to the contributed property should also be allocated to the members for the purpose of determining the difference between the tax basis of such property and its corresponding fair market value. This would have a bearing once the LLC experienced a net loss. The member would be allowed to deduct his share of the loss from his personal tax return up to the amount of the tax basis of his LLC interest. If the share in loss exceeds the LLC interest, the excess is allowed to be carried over and deducted when the member's LLC interest becomes positive during any subsequent year.

III. LLC INTEREST AND TAXATION

Under normal circumstances, no gain or loss is recognized when a member contributes property to the LLC. Consequently, no gain or loss is likewise recognized by the LLC when it distributes property to such a member, except when the money distributed exceeds the tax basis of the same member's LLC interest before the distribution occurred. In this light, a member's interest who acquires an LLC interest may come in two ways. First, when interest is acquired by means of an exchange for a capital account, interest will be equal to the amount of money tendered and the tax basis of the property such member contributed to the LLC pool. The second way is through purchase, gift, or inheritance from a member, in which case, the basis is subject to the general basis rules of the Code, particularly sections 1011 to 1023. To properly facilitate the determination of tax liabilities of members, it is imperative for the members to know the basis of their interest for:

* the computation of gain or loss when the member decides to sell the interest;

* the computation of gain or loss related to a distribution from the LLC;

* the determination of the basis in property distributed by the firm; and,

* the determination of the maximum amount of losses he may deduct from his individual income tax return.

In essence, an LLC interest is treated similarly with shareholdings in a corporation. It is an investment on an entity separate from the owners. The tax basis would increase mainly through three ways: the member's share in the liabilities of the LLC, by the share in the entity's income, and by additional capital contributions in future time. On the other hand, the tax basis would reduce by way of LLC distribution and losses, accorded to the member's predetermined share, and by actual reduction in the member's share in the liabilities (such as selling a part of the share). A member is thus considered to have made a cash contribution to the LLC equal to any increase in the LLC liabilities share, and to have received a cash distribution