L imited liability companies (LLCs) are a popular form of business organization. They have been referred to as hybrids because they offer the same personal liability protection as corporations but with the pass-through tax treatment of partnerships. First endorsed by the IRS 20 years ago, they remain the new kid on the entity block, with several issues still unresolved and many aspects misperceived. The plain truth about LLCs...

LLCs don’t save taxes. There is no “magic” federal tax savings from operating as an LLC. (Of course, you do avoid the double taxation inherent with C corporations.) Although the LLC is not itself a taxpayer, its owners (members) must report their share of LLC income, gains, deductions, credits, etc. on their personal returns. If there are two or more members, the LLC files a partnership return and allocates these items to owners on Schedule K-1. If there is a single member, LLC items are reported on the member’s Schedule C of Form 1040.

Using an LLC does not save state taxes, either.

Example: Owners based in California cannot avoid the California gross receipts tax by forming an LLC in Delaware (or any other state) if they do business in California. This is true even when they buy property in Oregon through an LLC formed in Oregon. Managing property from California subjects the LLC to California’s gross receipts tax.

LLCs formed in another state must register to do business in the state in which they operate. Failure to do so may mean there’s no personal liability protection for owners in the state in which they run the business.

LLCs are useful for estate planning. This is due to the ease with which funds can be transferred from one generation to the next. For instance, say a parent owns an LLC holding real estate and wants to transfer some or all of this to his two children on a tax-favored basis. Using the annual gift tax exclusion ($12,000 per recipient in 2007), he makes gifts of interests in the LLC to them each year with no transfer tax cost. The value of these interests for gift tax purposes is less than the allocable value of the underlying assets, effectively allowing more to be transferred tax free.

Example: A rental property, valued at $2 million, is held by an LLC owned by the parent. Applying a valuation discount of 40% because the interests given to the children are minority interests and are not marketable, the parent can transfer, tax free, $12,000 worth of the property to each child -- which actually represents $20,000 worth each. This can be repeated annually until the parent has transferred the desired share of the LLC.

Transferring interests to children during life can mean that when the parent dies, his remaining interests qualify for valuation discounts in his estate, making his estate worth less. (A discount for minority interests applies if the parent has transferred enough of the LLC to his children to bring his remaining ownership interest below 50%.) A “marketability” discount also applies.

For estate planning purposes, the LLC is superior to the S corporation because...

An LLC can make disproportionate distributions to the parent and children, allowing the parent to receive income from the business to whatever extent desired (assuming the company is profitable enough to pay and provided a complex set of rules is followed) throughout his life or to give children a greater share of income. The children’s share of income isn’t viewed as a gift from the parent (but they are taxed on income they receive). An S corporation must make proportionate distributions to shareholders -- disproportionate distributions can result in termination of the S corporation status.

The parent can retain control over the LLC throughout his lifetime by classifying the children as nonmanaging members -- this bars them from having a say in day-to-day operations. This approach cannot be used in an S corporation because different classes of stock are not allowed.

Heirs receive a stepped-up basis in the assets of the LLC, allowing them to claim greater depreciation deductions because new depreciation deductions will be based on the inherited property’s current fair market value. There’s no basis step-up for assets held by an S corporation.

LLCs don’t make it easy for owners tax-wise. The member pays tax on his portion of the LLC’s income, regardless of what’s actually distributed to him. Because a member is viewed as self-employed, he can’t receive wages from the LLC. A member can’t pay income taxes through payroll withholding and must file quarterly estimated tax payments.

Health insurance can’t be provided to a member on a tax-free basis. If the LLC pays the premiums, the amount is treated as a guaranteed payment to the member, increasing the distributive share picked up as income by the member. The member can, however, deduct 100% of the LLC-paid premiums as an adjustment to gross income on his personal tax return if he is otherwise qualified.

As yet, there’s no definitive guidance on whether and to what extent an LLC member is subject to self-employment tax. Experts agree that a member who’s a manager of the LLC is treated like a general partner, who is subject to self-employment tax on his distributive share. However, limited partners generally are exempt from self-employment tax.

Impact: Partners who are non-managers may be treated like limited partners, escaping self-employment tax on some, if not all, of their share of net income from the LLC.

Caution: The owner of a one-member LLC can be held personally liable for the employer share of payroll taxes with respect to employees. It had been argued that only the LLC (the entity) should be liable, but courts have concluded that a single-member LLC is a disregarded entity not only for income taxes, but also for employment tax purposes. Therefore, the owner cannot escape personal liability for failing to pay withheld income taxes and the employee share of FICA (Social Security and Medicare taxes) with respect to the LLC’s employees.