Taxation of Limited Liability Companies and Pass-through Entities Compared to “C” Corporations
1. Liability Protection. “C” Corporations and Limited Liability Companies provide similar protection of the personal assets of the shareholder/members.
2. “C” Corporations Are Not a Pass-Through Entity. Whereas, Limited Liability Companies are generally a pass-through entity and treated as a partnership for tax purposes.
3. Double Taxation. The “C” Corporation is subject to double taxation at both the corporate level and upon distribution to shareholders. A Limited Liability Company treated as a partnership has one level of taxation.
4. Phantom Income. “C” Corporations can accumulate earnings paying tax at the corporate level without the shareholders being individually taxed. The LLC, on the other hand, if it attempts to accumulate earnings, could make the shareholders subject to “phantom” income, therefore being taxed on income not earned. The “phantom income” issue is a simple concept. “Phantom income” arises where the shareholder has income for tax purposes and no money received from the LLC to pay for those taxes. If the Limited Liability Company earns income and then uses that income to purchase a capital good, the result is phantom income to the members. For example, if the LLC earns $100,000, and purchases a machine for $100,000, in the same year, the LLC has no income to distribute to the members. Nevertheless, the individual members are taxed on that $100,000 (minus the depreciation pass-through to the members) without receiving any money to pay those taxes. Other examples include where one group of members lends money to the LLC and then expects to be paid back at a rapid rate. The amount of money paid back to the member, which constitutes loan principal, is not deducted by the LLC and is subject to income tax for the members.
5. Retirement Plan Differences. LLC members who are treated as partners and own more than 10% membership interest cannot borrow against a qualified retirement plan account pursuant to IRC Section 4975. (This is similar to the “S” Corporation Shareholder who owns more than 5% of the corporation who is also prevented from borrowing against the qualified retirement plan account.) On the other hand, the “C” Corporation Shareholder/Employee can borrow against their qualified retirement plan.
6. Limited Number of Members. LLCs, although legally not limited to a particular number of members, are practically limited by Internal Revenue Code. IRC 7704 provides that if LLC membership interests are “widely held”, they are treated as “publicly traded.” If the LLC is considered “publicly traded”, then the LLC will be treated as a “C” Corporation for Federal Income Tax purposes.