by Arizona LLC Attorney Richard C. Keyt, JD, CPA
One of the advantages to forming an LLC is that it allows maximum flexibility for choosing a method of federal taxation. For instance, if an individual formed a limited partnership, the limited partnership must be taxed as a partnership. Whereas, an individual who forms a corporation must be taxed as either a C Corporation or S Corporation. However, the individual, who forms an LLC, has the whole panacea of federal tax alternatives to choose from. The individual may elect to be taxed as a partnership, taxed as a C Corporation, taxed as a S Corporation, or a sole proprietorship (if the LLC is a single member LLC). This article discusses the various methods of LLC taxation and some of the pros and cons of each method of taxation.
The Check The Box Regulations
Before discussing the four different methods of federal income taxation available to LLCs, it is important to discuss the tax implications upon forming a LLC. When the LLC is initially formed, federal tax law creates a default manner of taxation for the LLC based upon the number of members the LLC has. The default classification for a single member LLC, whose sole member is an individual, will be classified as a sole proprietorship. The default classification for a single member LLC, whose sole member is a corporation or partnership, will be classified as a disregarded entity for federal income tax purposes. A multi-member LLC will have a default classification as a partnership.
These default classifications are important, because if the member(s) wish to change the federal tax classification of the entity, then they must file an IRS Form 8832. If the newly formed LLC does not file this form, the default classification would apply to the newly formed LLC. Further, if a newly formed LLC wishes to be taxed as an S-Corporation, it must file an IRS Form 2553 in lieu of Form 8832.
Note the time restrictions on each form. Form 8832 does not have to be filed immediately and may be filed at any time during the entity’s existence subject to certain limitations. The instructions to Form 8832 provide that an election will not be effective 75 days before the election is filed.
Sole Proprietorship Method of Federal Income Taxation
A sole proprietorship is the default classification for a single member LLC. Only a single member LLC may be taxed as a sole proprietorship. A sole proprietorship does not have to file any separate tax returns, and is a disregarded entity for federal income tax purposes. The member of the LLC reports all the economic activity of the LLC on their personal income tax return on Schedule C. The taxpayer then pays any tax associated with the LLC on their personal income tax return.
A major advantage to having an LLC taxed as a sole proprietorship is the ease of reporting the income or loss of the LLC. The sole proprietorship does not need to file an additional tax return unlike the C Corporation, S Corporation, or partnership. This is advantageous because the LLC does not have to prepare a balance sheet and other schedules which may be required on the tax returns for the other methods. This allows many small business owners to focus more time and money on their business, rather, than having to pay an accountant or prepare the additional tax forms themselves.
There are two major disadvantages to the sole proprietorship. The first disadvantage is that taxpayer’s who file Schedule C tend to get audited at a higher rate than taxpayers who do not. The higher audit ratio means members must be especially diligent in maintaining documentation supporting any deductions they claim associated with the LLC. This means keeping receipts and other supporting items for at least 3 years after the return has been filed. If the member fails to do so, the IRS may disallow many deductions during an audit and the taxpayer may be faced with a substantial tax bill.
The second major disadvantage associated with sole proprietorship taxation is that the member must pay self employment tax. An employee pays 6.2% for social security on the first $106,800 of wages and 1.45% for medicare on all wages. Self employment tax is similar to payroll taxes (social security and medicare) paid by employees. The key difference is that the member of the LLC must also pay the employer’s portion of social security and medicare. Generally, self employment tax is calculated by taking the sole proprietor’s net earnings from self-employment which includes any allowable business deductions. The LLC member pays 12.4% for social security on the first $106,800 of net self employment earnings and 2.9% for medicare on all net self employment earnings. With self employment tax, the member must pay both the employee and employers share of the payroll taxes on self employment income. They are paying double the amount of payroll taxes they would have to pay if they were an employee. However, the member does receive a tax deduction for one half of the self employment taxes paid for the tax year.
C-Corporation Method of Federal Income Taxation
A LLC may also be taxed as a C-Corporation. The default classification for a LLC will never be a C-Corporation. Therefore, the LLC must file Form 8832 to elect to be taxed as a C-Corporation. This form can be filed anytime after the LLC has been formed, but the time the LLC will begin to be taxed as a C-Corporation cannot be more than 75 days before the date of filing with the IRS.
A C-Corporation is considered a separate entity for federal tax apart from its shareholders. The C-Corporation must file its own tax return and pay whatever tax is owed. The C-Corporation files a Form 1120. The C-Corporation is becoming increasingly less relevant as an effective method of paying reduced taxes, because individual income tax rates have dropped substantially. The decrease in individual income tax rates has brought the individual rates roughly equal to the corporate tax rates. Because the rates are now roughly equal which prevents shareholders from using the C Corporation to shelter income, more people use partnerships or S-Corporations to take advantage of the tax saving opportunities that those two forms offer over the C-Corporation.
The major problem with the C-Corporation is the concept of “double taxation.” The government taxes corporate earnings as the corporation earns the income and taxes the earnings again when the corporation distributes the money to shareholders. Assume the XYZ Corp had $100 of taxable income at year end. The C-Corporation’s income is taxed at a 20 percent rate. XYZ Corp would be required to pay $20 in tax. The C-Corporation now has $80 in after tax earnings. Now assume that XYZ Corp makes a distribution to its sole shareholder of the entire $80 as a dividend. Assume the dividend will be taxed at a 20 percent rate as well. The shareholder would have to pay $16 of income tax on the distribution from XYZ Corp. Taken together the shareholder has paid $36 in taxes or 36 percent of the LLC’s income.
A shareholder of a C-Corporation might try to avoid paying taxes on dividends by not making any dividend distributions and keeping all earnings within the C-Corporation. To prevent people from utilizing this strategy, Congress enacted the accumulated earnings tax (“AET”). The AET gives the IRS the ability to assess taxes against a C-Corporation for failing to pay dividends to their shareholders. If the IRS believes a corporation has accumulated excess earnings, it can assess this penalty tax against the corporation. The tax rate of the penalty coincides with the tax rate shareholders pay on dividends.
Another disadvantage of C-Corporation taxation, is that capital gains are not subject to a preferential rate. Most individuals receive the benefit of paying a lower rate on capital gain income. Capital gain income is typically the income associated with selling stocks, bonds, or from other capital assets. With a C-Corporation, capital gain income will be taxed at whatever the corporate tax rate is. Compared to an S Corporation or Partnership whose capital gain income would flow through to the individual where it would be subject to the special rate. Further, capital losses would be kept inside the C-Corporation and could only be utilized by the corporation; whereas, with the S Corporation or Partnership, the capital losses could be used to offset any capital gains the individual taxpayer might have.
S Corporation Method of Federal Income Taxation
S-Corporations are a pass through entity taxed under subchapter S of the Internal Revenue Code. A pass through entity does not pay tax; rather, the S-Corporation passes earnings and losses through to the shareholders. The shareholders then report the earnings or losses of the S-Corporation on their personal income tax return. There are a few unusual situations under which a S-Corporation might pay tax. One situation occurs when converting a C-Corporation into an S-Corporation. If you have a LLC taxed as a C-Corporation and want to change the method of taxation to a S-Corporation, then any assets of the C-Corporation which have appreciated in value could be subject to the built-in gains tax.
A LLC must elect to be taxed as an S-Corporation. This is done by filing a Form 2553. The filing of the form is time sensitive. See the instructions to Form 2553 for more details on when and how to file.
In order to be eligible for S-Corp taxation, the members of the LLC must meet certain eligibility requirements. The limited liability company must be a domestic LLC meaning it is formed within the United States. The LLC cannot have any members who are partnerships, corporations, or non-resident aliens. Also, certain types of trusts may not be members of the LLC. The LLC cannot have more than 100 members. Further, certain types of businesses such as financial institutions, insurance companies, and domestic international sales corporations are prohibited from being taxed as a S-Corporations. Keep in mind the that the prohibitions against different types of LLC members are very important. If the LLC either admits a new member, who is of the prohibited type or another member disposes of their interest to a prohibited type of member, the S-election will be terminated leading to disastrous tax consequences.
The S Corporation offers many tax benefits. S-Corporations do not suffer the sting of double taxation associated with C-Corporations, because the S-Corporation passes through all the economic activity to the shareholders. Shareholders, generally, do not pay have to pay tax on distributions they receive from the S-Corporation unless the distribution exceeds their stock basis in the S-Corporation.
Owners of entities taxed as S-Corporations calculate their stock / membership interest basis using the following formula. The owner adds any contributions of either cash or property which the owner made to the S-Corporation, and deducts any distributions that the owner receives from the entity. If at the end of the tax year the entity made a net profit, the owner would add the owner’s share of the entity’s profits to the owner’s stock / membership interest basis. However, if at the end of the year the entity has a net loss, the owner will decrease the owner’s stock membership interest basis by the amount of the net loss.
- Stock or Membership Interest Basis = Contributions of Money/Property + Corporate Earnings – Distributions of Money/Property – Corporate Losses
The ability of an owner of an entity taxed as an S-Corporation to deduct losses on the owner’s personal income tax return depends upon the owner’s stock / membership interest basis. An owner may only deduct a loss to the extent of the owner’s stock / membership interest basis. For instance assume the entity taxed as an S-Corporation has a $100 net loss for the year, and the owner has stock / membership interest basis of $50 at year end. The owner can deduct $50 of the loss on the owner’s personal income tax return. The remaining loss is suspended and may be deducted when the owner has sufficient basis in their stock / membership interest to take the loss.
Entities taxed as S-Corporations can minimize the sting of the self-employment tax. An owner of an entity taxed as an S-Corporation can be treated as an employee. The entity pays the owner a reasonable salary for the services which the owner performs on for the entity. The entity pays the payroll taxes with respect to the owner’s wages. The entity may deduct the owner’s wages and corresponding payroll taxes associated with those wages in computing the entity’s net income. The owner reports the wages as ordinary income on the owner’s personal tax return. The owner may also report the owner’s share of the entity’s net profits on the owner’s personal income tax return. However, the owner does not have to pay any self employment taxes on the entity’s profits. Under the sole proprietorship method of federal income taxation, all of the net profits are subject to the self-employment tax.
One key difference between the S-Corporation and partnership methods of taxation concerns the allocation of profits and losses. With a partnership, the partners can choose to allocate income and losses any way they choose as long as those allocations comport with “substantial economic effect” requirements of Internal Revenue Code Section 704(b). The entity taxed as an S-Corporation must allocate all profits and losses pro-rata based on the owner’s ownership interest in the entity. If there were two shareholders of an entity taxed as an S-Corporation with owner A owning 10% and owner B owning 90%, owner B must be allocated 90% of any profit and loss, and owner A must be allocated the remaining 10%. Further, distributions made by the entity to the owners must be made pro-rata. If the entity fails to follow these rules regarding profit and loss allocations and distributions, then the IRS can terminate the entity’s S election.
Partnership Method of Federal Income Taxation
The other way an LLC can be taxed is as a partnership. The IRS default classification for a multi-member LLC is partnership taxation. A LLC with only husband and wife as members may elect to have the LLC treated as a partnership. The married couple must file Form 8832 to do so. The partnership must file a tax return on Form 1065. The return is for informational purposes only.
The partnership is similar to the S-Corporation method of income taxation in that the entity is considered a pass-through entity. The owners of an entity taxed as a partnership must report all the economic activity of the entity on the owner’s personal income tax returns. Owners have a tax basis in their partnership / membership interest, but partnership basis rules are much more complex than the basis rules that apply to entities taxed as S-Corporations and are beyond the scope of this article.
Entities taxed as partnerships, unlike entities taxed as S-Corporations, can specially allocate income and losses to the owners. However, the Internal Revenue Code requires that allocations of income and losses must have substantial economic effect. The IRS briefly summarizes substantial economic effect as:
“Such flexibility comes with strings attached. Partners are not able to allocate tax benefits among themselves in a manner that is divorced from their allocation of economic profit or loss. A partner who is economically enriched by an item of partnership income or gain is required to shoulder the associated tax burden. Similarly, a partner who is economically hurt by an item of partnership loss will be allocated the tax benefit of the loss. The tax allocations must ultimately conform to the economics of the partnership’s transactions.”
If the IRS does not view the entity’s allocations of profits and losses as having substantial economic effect, then the IRS will reallocate the items based on the owner’s percentage interest in the entity.
Entities taxed as a partnerships may also make guaranteed payments to the owners. IRS Publication 541 defines a guaranteed payment as:
“Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership’s income. A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. This treatment is for purposes of determining gross income and deductible business expenses only.”
Thus, an owner of an entity taxed as a partnership cannot receive wages for services performed on behalf of the entity. The amount of money the owner would have received in wages is treated as a guaranteed payment. The guaranteed payment will be subject to self employment taxes on the owner’s individual tax return.
The self employment tax issue has created controversy within the context of LLCs taxed as partnerships. Before the advent of the LLC, the general rule was that limited partners of limited partnerships did not have to pay self-employment tax on their distributive share of partnership income, but general partners were required to pay self employment tax on their distributive share of partnership income. Because the legal structure of the LLC differs from that of partnership, such a rule is not easy to apply to LLCs. An LLC does not have the equivalent of a general partner. Members of a LLC all have limited liability, so it seems as though it would be easy to apply the limited partner rule to the LLC. The IRS has taken a different position examining the facts and circumstances surrounding each situation to determine whether LLC members must pay self employment tax. For instance, if the LLC is manager-managed and the member does not serve in the role as a manager, then the member probably would not have to pay self employment tax. The bottom line is that you should consult with your tax adviser to determine the correct reporting requirements for your situation.
Entities taxed as a partnership are not subject to the double taxation problem that plaques entities taxed as C-Corporations. However, one of the drawbacks of the partnership method of taxation is that the reporting requirements can be much more complex than that of the other entities. The instructions to Form 1065 alone estimate that one should spend 35 hours on keeping and maintaining partnership records, 24 hours on learning about the law and form, 35 hours preparing the form, and 3 hours copying and assembling the form to send to the IRS. This amounts to 97 hours spent on completing your partnership informational tax return.
The LLC offers its owners the most flexibility and choice (the four methods described above) as to the type of federal income taxation that will be best for the owners’ particular situation. The good news is that when you form an LLC, you have 75 days to consult with your tax advisor, determine which of the four tax methods is best for your company and make an election to change the default method of income taxation by filing either an IRS Form 8832 (to elect to be taxed as a C -Corporation) or an IRS Form 2553 to be taxed as an S-Corporation).
Nothing in this article is intended to be legal or tax advice, but rather is a general description of the types of taxation one may elect when operating an LLC and some of the general characteristics of each structure.
Disclaimer: Circular 230 Notice: Pursuant to recently-enacted U.S. Treasury Department regulations, I am required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.