Trap For LLCs Taxed As Corporations
LLCs have become increasingly popular on the past two decades. We know they are perfect for holding investment
property, but some like using them for business pursuits as well. If the LLC does not elect otherwise for tax purposes, it is a disregarded entity where there is only one owner and taxed as a partnership when there are
two or more owners.
The problem is that all earned income (e.g. quick-turn property, development, selling widgets, etc.) generated by the LLC will be taxed as earned income to the members of the LLC, with few exceptions. Therefore many investors
under advice of their attorney or accountant, have had their LLCs that generate earned income, elect corporate
status, either C or S. This means the entity will be treated as an LLC for civil law purposes and as a C or S
corporation for tax purposes.
Most discussions of this topic end there. But there is a trap waiting for those who elect corporate status for their LLC. Unless there is an operating agreement specifically modified to allow for this election, the LLC could be a tax trap waiting to happen. And there must be a written operating agreement because the state default rules will not cover this.
Here are just a few examples:
Once taxed as an S corporation, allocations of profits and losses must be allocated based on the ownership interest. There can be no disproportionate allocations or other level of allocation, such as preferred return, as that may be treated as a second class of stock (thus terminating S status and having the LLC taxed as a C corporation). Eliminate all of the language and reference to Treasury Regulations 1.704-1(b) through 1.704-4. Reprinted by Permission. Copyright 2008 Dyches Boddiford. All Rights Reserved. The Oaks Group, PO Box 505, Marietta, GA 30061. Dyches is a National Speaker has been a MREIA featured speaker at past meetings. Visit www.assets101.com for more information.