How are LLCs Taxed in California?

When an LLC chooses how it wants to be taxed, the IRS provides a form called “the check box” form or form 8832. This form was created to simplify the process of selecting how an LLC would like to be treated for taxation purposes. All LLCs, whether single or multiple members should use this form.

Limited Liability Companies that are Taxed as Partnerships or S Corps

Generally, limited liability companies that have more than one member usually choose to be taxed like a partnership. There are times, though, wherein multiple-member LLCs choose to be treated as either a C corporation or an S corporation. If they choose to be taxed like a C Corp, they lose the pass-through tax benefits that are offered in a partnership tax treatment. If they choose to have an S Corp taxation treatment, they are limited with respect to how many members they can have and are prohibited to have non-citizen or resident alien ownership.

Limited liability companies that choose to be treated like a partnership for taxation purposes are subject to subchapter K of the Internal Revenue Code that governs the taxation of partners and partnerships. This means that the business is subject to only a single Federal Income Tax at the members’ level with each member reporting his or her share of each item in the company’s gain, loss, income, deduction, or credit on this personal tax return.

If a limited liability company chooses to be taxed like an S Corp, the restrictions on the equity and capital structure can greatly limit the flexibility in strategic planning for the company. There will be limits in growth, changes in types of stock, inter-generation business transfers, etc.

Basis of Member Interest in a Limited Liability Company

The members of an LLC that has chosen to be taxed as a partnership are taxed based on their LLC interest. Each LLC member’s interest is obtained from the contributions or payments for their membership. The basis in these membership interests is separate from the company’s basis in its assets. In other words, the company’s interest is treated as an interest in a separate entity just like a stock in a corporation. Each member of an LLC must know the basis of his or her interest for many tax purposes including the following:

Limited Liability Company Distributions to its Members

Members of an LLC

The distributions of an LLC to its members are treated as a non-taxable withdrawal of the members’ investments up to the level of his membership interest. Each LLC member will receive distributions of partnership property without recognizing a gain or incurring a loss. The only time a gain is recognized is when the distribution exceeds the member’s level of investment or membership interest. Losses may not be recognized on a distribution either unless the distribution consists solely of liquid assets, cash, or unrealized receivables. The losses, if recognized, are limited to the difference between the member’s basis for interest and the sum of the distribution. These gains or losses are considered capital gains or losses for taxation purposes.

The Tax Consequences of Capital Contributions in an LLC

Cash contributions in a limited liability company are comparable to the cash contributions in a corporation or a partnership. No gains or losses are recognized with these contributions. The contributors’ bases for the interest they receive are considered equal to the amount of money he or she contributes.

Property contributions, on the other hand, have a different impact. Gains or losses in a property that has been contributed are deferred in an LLC until the partnership sells that asset or the contributing member decides to sell his or her share in the business. The member that contributed the property does not recognize gains or losses at the time of the contribution, irrespective of his or her ownership allowed in the LLC’s operating agreement. It is only if the LLC sells the contributed property that those gains or losses can be recognized and allocated to the contributing member.

On the contrary, in a C corporation and an S corporation, the transfer of appreciated property in exchange for stock interest is taxable unless the contributor controls the business. The contributor may have control over the LLC if his or her ownership is at least 80% of the stock.

In a C Corp, the company is taxable on gains or losses when it disposes of contributed properties. This, though, has no tax consequence to the stockholders. On the other hand, in an S Corp, the gains or losses are recognized when it disposes of properties. These gains or losses are passed through to the shareholders and are in direct proportion to their stock ownership. The gains or losses are not allocated to the contributing stockholder.