Trap For LLCs Taxed As Corporations



by Dyches Boddiford


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:


  • Whereas anyone can own interests in an LLC, only certain persons are eligible to be owners of an S corporation. This applies to an LLC which chooses to be taxed as an S corporation as well. A prohibition as to transfers to such ineligible persons should be incorporated in the operating agreement and any clauses to the contrary removed.


  • The provisions in an LLC Agreement relating to profits and losses will no longer refer to partnership tax regulation IRC 704(b) because the LLC will not be taxed as a partnership. There is no longer any need to, nor should there be a provision for capital accounts.


  • The Operating Agreement should show that the members have elected to have the LLC treated as an S corporation for tax purposes. If the members make this election at the formation of the LLC and reflect such in the operating agreement, separate meeting minutes or consent are not necessary.


  • Distributions must be shared based on ownership and any distributions should be made to all owners at the

same time.


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 for more information.