LLC Taxation

Taxation of LLCs

Introduction:

Limited liability companies (LLCs) are essentially partnerships with "entity" status similar to a corporation. LLC owners are called "members" (which can be individuals, corporations, or other LLCs). Florida. like most states, permits "single-member" LLCs. Aside from the tax aspects, LLCs are governed by Chapter 605 of Florida Statutes

LLCs have flexibility as to how they want to be taxed. Click Here for IRS Publication 3402 ("Taxation of Limited Liability Companies")

Follow the rules when disbursing money to the owners of an LLC (read the article entitled "The Basics of Paying Yourself As an Entrepreneur")

Choices on How LLCs are Taxed

Single member LLCs.

By default a single member LLC is "disregarded" for federal tax purposes and does not file its own return. All of its income, deductions, credits, etc. are reported on the tax return filed by the sole member.

A single member LLC is disregarded ONLY for tax purposes. For all other purposes it is a separate legal entity that can shield its owner from some of the liabilities that might arise out of the operation of the LLC's business.

Multiple Member LLCs

taxed as partnerships

Electing to be Taxed as a Corporation

Both single member and multiple member LLCs can elect to be taxed as a corporation. After making the election the IRS will treat the ownership interests of the LLC members as if they were stock holdings in a corporation.

Use IRS Form 8032 if the LLC elects to be taxed as a so-called "C-corporation")
Use IRS Form 2553 if the LLC exlects to be taxed as a so-called "S-Corporation"

An LLC taxed as a C-corporation will not be treated as a pass-through entity and it must file its own annual tax return (Form 1120).
Unlike a C-corporation, an S-corporation is a "pass-through" entity that pays no tax at the company level. all company income, losses, deductions and credits pass through to shareholders/members for federal tax purposes. Shareholder/members then report the flow-through income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

CLICK HERE to read an article on the differences between "S" and "C" corporations.

QUALIFICATION AS AN S-CORP: To qualify as an S-corporation the members of the LLC must meet all of the same IRS requirements that the shareholders of a corporation would have to meet. The main ones include:

the LLC may have only one class of members.

The LLC may have no more than 100 members

All of the LLC's members must be natural persons meaning that none of them can be LLCs or corporations (with the exception of 501(c)(3) corporations).

All of the members must be U.S. citizens or lawful permanent residents

S Corp Shareholder Tax Liability

If any member of an LLC taxed as an S-Corp (hereinafter referred to as a "shareholder") does substantial work for the business, her or she are considered to be employees and therefore subject to federal employment taxes - i.e. Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) plus federal income tax withholding. It doesn't matter if the shareholder is company officer; as long as that person performs a service for the company and receive payment, those payments are considered wages. And, bottom line, wages are taxable income, and must be reported on the shareholder's personal income tax return.

BIG ADVANTAGE BEING TAXED AS AN S-CORP. If an LLC is NOT taxed as an S-Corp the owners must pay federal employment tax on their ENTIRE share of the company's profits (even if those profits are not all distributed to them). If, on the other hand, the company elects to be taxed as an S-corp the owners pay federal employment tax ONLY on the amount of their own salaries

Unlike public companies, which pay out dividends to shareholders from their corporate income, S Corps pay out distributions - a share of the company's net profit. C Corp dividends are subject to taxes and S Corp distributions are not. Where business owners get in trouble is when they try to pay themselves a miniscule salary and take their compensation in the form of a distribution to avoid paying FUTA and FICA payroll taxes on their income. The IRS and Social Security Administration are on the lookout for those trying to avoid payroll taxes, and if caught, your business will lose its S Corp status.

The IRS also expects S-Corps to pay such shareholders a "reasonable salary".&nsbsp; What's considered reasonable is clearly dependent on the industry and the scope of the shareholder's duties. To stay on the right side of the IRS, it's a good idea to research average salaries for comparable positions and adjust the salary accordingly.

If the IRS decides that such a shareholder is "substantially underpaid" for the services being provided, it can require adjustments be made to the income and expenses of both the shareholders'tax returns and the company's tax returns.

New Tax Deduction for "Pass Through" Entities

The Tax Reform Act of 2017 provided a new deduction for certain "pass through" entities of up to 20% of the income earned (calculation of the exact amount is somewhat complicated).

"Pass through entities" include LLCs taxed as either partnerships or S Corporations

ELGIBILITY

The entity must be engaged in a "qualified trade or business"

EVERY pass through entity is a "qualified trade or business" EXCEPT for (1) businesses solely involved in the performance of services as an employee and (2) the sole business is to provide personal services (e.g. doctors, lawyers, accountants, etc).

Self-Employment and FICA Taxes

FICA vs Self Employment Tax

The Self-Employment tax is a 15.3% tax that is paid for Social Security and Medicare. It is most commonly paid by individuals who work for themselves. It is also paid by owners of "pass-through" entities such as partners in a partnership, members of LLC's that are taxed as a partnership, and (generally) stock holders of an S corporation

The FICA tax is similar but the payment is split between an employer and its employees). With FICA the employer pays half and the employee pays the other half (through payroll deduction).

CLICK HERE to read an article about the differences between FICA and the Self Employment Tax.

LLCs Taxed as Partnerships or Disregarded Entities

The Defaults:

Single Member LLCs - By default, a single-member LLC is a disregarded entity for tax purposes and is treated by the IRS as a sole proprietorship. Just like any other sole proprietor, the owner of this type of LLC is considered to be "self-employed" and thus, in addition to income tax, the sole member must pay a the self-employment tax calculated upon the ENTIRE net earnings of the company whether or not those earnings are distributed to the member by the company

Multi-member LLCs - By default, mult-member LLCs are taxed as partnerships. Each member pays self employment tax calculated on the entire net profit of the company (whether or not distributed) in proportion to their respective ownership share

Owners vs Non Owners When Providing Services to an LLC

Non-Owner Employees: Non-owner formal employees of all LLCs are subject to FICA, thus, there is withholding of half the employment taxes due (with the company paying the other half).

Form W-2 (for workers that are employees) and Form 1099 (for workers that are independent contractors) must be filed when required.

Services Provided by LLC Owners; Owners of LLCs are NOT considered to be employees by the IRS even if they are receiving compensation pursuant to a formal agreement. Self Employment Tax is owed on each owner/member's entire share of the profits even if some of those profits have been characterized as salaries by the LLC.

LLCs Electing to be Taxed as S Corporations.

Salary for work done as an employee, and
distribution of net profits (after taking the deductions for salaries and other expenses)

Salaries

The IRS requires that ALL owners of S corporations that regularly perform services MUST be treated as employees and that FICA tax must be paid on their salaries. S corporations that have no formal employees yet report substantial profits invite an IRS audit.

No Self Employment Tax is paid on profits (beyond the FICA paid on salaries)

Compare this to entities taxed as partnerships or disregarded entities where Self Employment tax is paid on the owner's share of all profits.

Owners that are providing services typically seek to minimize their salaries in order to reduce their exposure to the FICA tax.

Warning: the IRS frowns on companies that are being taxed as S corporations and which are reporting profits yet pay unreasonably low (or no) salaries to owners that are providing significant services. As a general rule the amount paid should correlate to what the company would have to pay a non-owner employee for the same services

LLCs Being Taxed as C Corporations.

The owners of an entity being taxed as a C corporation pay no self-employment tax on their share of the profit. If a owner is also a formal employee he or she is subject to payment of FICA employment tax through salary withholding the same as any non-owner employee.

Because the employment tax is not an issue the primary concern of the owners is typically to structure compensation so as to reduce taxable income on the corporate level, thereby reducing exposure double taxation.

Some Advantages of an LLC Being Taxed as a C Corporation

LLCs being taxed as C corporations can offer deferred compensation benefits. Often the sole stock-holder of a C corporation will want reduce his or her "salary" so as to leave more money in the company. This is because the corporate tax rate on the first $75,000 of corporate income income is LOWER than the tax rate the owner/employee would pay if the money was taken as salary.

An LLC taxed as C corporation can offer employees nontaxable fringe benefits (such as health insurance and retirement plans) which can be deductible business expenses for the company

Like an S corporation (but unlike an LLC being taxed as a partnership or as a disregarded entity) the members of LLC's being taxed as a C corporation do not pay FICA tax on their share of the company's profits but only on the salaries that they earn as formal employees. But, unlike corporations where the employees pay 100% of the FICA owing on their salaries with a C corporation the company pays 50% of the FICA and the employee pays only the other 50%.

Special Issues When LLCs are Taxed as Partnerships

Have Caution When Setting the Split of Profits:

As a general rule the IRS regulations require that profits to be split by the same percentage as the percentage of each member's investment in the company.

But, the IRS will allow profits to be split by some other percentage (a "special allocation") PROVIDED such profit split has a "substantial economic effect". For there to be a "substantial economic effect" the LLC's Operating Agreement MUST provide for the following:

"Capital accounts" must be maintained as specified in the IRS regulations

The capital account of a member consists of his or her capital contributions plus his or her share of the profit reduced by distributions made and the member's proportionate share of the companies losses.

Click Here for an outline on how to set up an LLC accounting system that tracks member capital accounts.

Upon liquidation negative capital accounts must be repaid by the members in question.

If the LLC Operating Agreement splits profits by a special allocation but without there being a "substantial economic effect" the IRS, upon audit, could reallocated the profits amongst the members in accordance with their actual interest in the partnership as determined from all the facts and circumstances. This could lead to a determination that certain members had underpaid their taxes (accompanied by penalties and interest on the underpaid amount). CLICK HERE to view 26 CFR 1.704-1

"Guaranteed Payments" vs "Distributions"

Money paid by the LLC to a member can be classified as either:

"Distributions": These are either payments made to members out of current earnings or payments made to members during liquidation of the company.

A distribution is made from an equity account and is thus shown as a reduction of the member's capital account.

"Guaranteed payment": A regularly scheduled payment for services rendered by a member, treated similar to the treatment of salary

Guaranteed payments are paid out of an operating account not a capital account. Guaranteed payments are a deductible business expenses whereas distributions are not. Thus, guaranteed payments, like all deductible business expenses, reduce the LLC's taxable income.

A member receiving a guaranteed payment is taxed on the payments similar to the way salary is taxed EXCEPT that the member must also pay self-employment tax on the guaranteed payment (as well as paying self employment tax on his or her share of the LLC's profits as is true for all the members).

Because of the tax deduction taken by the company for guaranteed payments the amount of profits are reduced thus reducing the self employment tax obligation of the other members.

A "guaranteed payment" reduces the capital accounts of ALL members because it is a tax deduction that reduces the amount of profit allocated to the capital accounts. A "distribution", on the other hand, reduces ONLY the recipient-member's capital account.

Guaranteed payments must be paid even though a net loss might result for the LLC. Unlike distributions, the right to receive a guaranteed payment is not contingent upon earnings. Guaranteed payments are treated as an operating expense.

Guaranteed payments made to worker-members are reported on Schedule K-1 of IRS Form 1065 (the partnership informational return)

CLICK HERE FOR MORE INFORMATION ON "GUARANTIED PAYMENTS"

Limits on the Deductability of Operating Losses:

For LLCs taxed as pass-through entities (either as a partnership or an S Corporation) the LLC member's ability to deduct business losses is limited by the following:

The only losses that can be deducted are those for which the LLC member is personally "at risk" - IRS Code Section 465

For losses resulting from "passive activity" the amount of the loss that can be deducted may be limited (IRS Code Section 469)

The amount of a loss that can be deducted is limited by the tax basis of the member's interest in the LLC - see sections 704(d) and 1366(d) of the IRS Code.