By default are "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.
Multiple Member LLCs:
By default are taxed as partnerships and must file a partnership informational return (IRS Form 1065).
As such, no tax is paid directly by the LLC. All of the taxable income, credits and deductions pass through to the members and are reported on their individual returns in proportion to their respective ownership interest in the LLC.
What is a "pass through" entity?
Profits generated by the business are not taxed at the entity leiver but, instead, are passed through and taxed directly to the owners on their individual tax returns. Pass through entities include
S Corps
partnerships
LLCs that elected to be taxed as partnerships
New Deduction for "Pass Throughs"
The tax reform act of 2017 provided a new generous new deduction for certain pass through entities an an amount of up to 20% of the income earned (calculation of the exact amount can be complicated).
Requirements for the New Tax Deduction
Must be a "qualified trade or business" - EVERY pass through entity is a qualified business, EXCEPT for
a trade or business that solely involves the performance of services as an employee or
the sole business is to provide personal services (e.g. doctors, lawyers, accountants, etc).
Electing to be Taxed as a Corporation
Both single member and multiple member LLCs can elect to be taxed as a corporation using IRS Form 8832 (the "check the box" form)
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 to be taxed as a "C-corporation"
Use IRS Form 2553 to be taxed as an "S-Corporation"
FICA vs Self Employment Tax - Similar yet different:
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 an LLC that has elected taxed be 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).
Don't confuse "FICA/Self-Employment Tax" with "Income Tax" - they are a different type of tax
LLCs that have elected to be taxed as an S Corp can distribute money to the owner/members in one of two ways:
Salary for work done as an employee, and
distributions of net profits
Salaries for S corps with one or two owners
Self Employment Tax Less Expensive with S Corp than with other types of pass through entities
. With most pass through entities the Self Employment tax calculated based on 100% of an owner's share of the profits whereas with an S corp the Self Employment Tax is based only on the owner's salary as an employee and not that person's share of the total profit
UNLIKE LLC's that are taxed as partnerships, in an S Corp the Self Employment tax is based on:
the owner's salary, and NOT
the owner's share of the profits
The IRS requires that ALL owners of S corporations that regularly perform services MUST be treated as employees and that "FICA" (not "Self Employment" tax must be paid on their salaries. (note: unlike a C corporation, the "employee" of an S Corp pays 100% of the FICA tax owed (i.e. the company does not pay half).
Salaries must be reasonable: A simple approach that helps S corporation owners determine a reasonable salary for themselves is the "60/40" approach. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.
S corporations that have no formal employees yet report substantial profits invite an IRS audit.
"Dividends" vs "Distributions"
When C Corp distributes its earnings to shareholder it is called a "dividend" . Shareholders and the IRS receive Form 1099-DIV.
S-Corps generally do not make pay dividends. S-Corps make non-dividend "distributions"
Distributions are taxed as ordinary income on the shareholder's personal tax return
Because S-Corps are pass through entities the shareholders are going to be taxed on that income whether it stays on the S-Corp's books or whether it's distributed to the shareholders as ordinary income
Thus, distributions, in and of themselves, are tax-free (because a shareholder will pay income tax on his or her share of the profits regardless of whether the distribution is made or not.
provided, of course, that the distribution does not exceed the shareholder's stock basis (If the distribution exceeds the shareholder's stock basis the excess amount is taxable as a long-term capital gain)
The tax "basis" of S Corp stock is calculated as follows: the price paid for the stock PLUS the amount of any undistributed share of the profits. Thus distributions reduce the basis of the stock
LLC "Guaranteed Payments" vs "Distributions"
Money paid by the LLC to a member can be classified as either:
"Distributions": Payments made to members out of current earnings. A distribution is made from an equity account and not an operating 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 similar to the a salary. Unlike a distribution, guaranteed payments are a deductible business expenses which reduce the entity's taxable income.
Advantages of Being Taxed as a C Corporation
Can can offer deferred compensation. Because the 21% corporate tax rate is significanlty lower than individual rates the sole stock-holder of a C corporation can reduce his or her "salary" so as to leave more money in the company.
A C corporation can offer employees nontaxable fringe benefits (such as health insurance and retirement plans) which can be deductible business expenses for the company
Unlike S 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%.
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.
Minimizing tax for C corporations
Earnings Bailout
Dividend distributions are NOT tax deducible for the corporation. This can be minimized by a "bailout strategy".
The idea is to maximize the salary paid to shareholder employees. But the compensation must be reasonable for the services actually rendered. If it isn't, it may be re-characterized as a dividend.
Such compensation is deductible by the corporation so that the income is only taxed once, at the shareholder level.
In service corporations where the services are rendered by the shareholders, stripping out all of the earnings of the business through the use of compensation payments usually can be easily justified.
Bracket Racket
The corporate tax rate on that retained income is lower than the tax rate that would be paid by stockholders if it had been distributed as dividends.
bail out the bulk of the gross revenue as deducible salaries (must be "reasonable") so as to keep the net corporate income below a certain
Don't distribute the remainder as dividends (thus keeping the money within the company).
The corporate tax rate on that retained income is lower than the tax rate that would be paid by stockholders if it had been distributed as dividends.
CAUTION - too much retained cash can result in corporation paying the "Accumulated Earnings Tax"
Exit Strategy - Future Sale Potential of the Company
The idea is to minimize the capital gains tax paid in the event that the company's assets were sold with the proceeds being distributed to the owners
Creating a C-corporation is usually NOT the best choice.
Sell Out "Hit": stockholders of C corporations fare poorly when substantially all of the assets are sold and the proceeds are then distributed to them.
First Hit (tax paid at the corporate level): Capital gains tax is paid at the corporate level at the regular corporate tax rate
Second Hit (tax paid at the shareholder level): Distributions to the stockholders are taxed again as a "capital gains distribution" (at the normal capital gains rate of 15-20%)
How the Gain is Calculated: The amount of the tax is the difference between the amount of the distribution and the stockholder's basis of the stock
No "Basis Booster" (Ouch): With C corporations there is no tax reducing "basis booster" as there is for the stock of S corporations and the ownership interests of entities taxed as partnerships (see the discussion below).
Tax Free Exit by Stock Swap: With C corporations the capital gains tax is avoided when stock is swapped for qualifying stock in another corporation.(Section 1045)
Compare Treatment of S-Corporations
There is no double tax on capital gains for S-corporations when the entity liquidates because there is no tax paid at the entity level
Any capital gains is paid by the shareholder/member BUT THERE IS A "BASIS BOOSTER" - Unlike stock in a C corporation, there is no locked-in basis for the stock (or LLC membership interest) of an S Corporation. Instead, there is "basis booster" provision in the Code that (when applicable) reduces the amount of gain when the stock is sold or when the corporation liquidates capital assets (thus reducing the amount of "capital gains" tax that must be paid).
How the "Basis Booster" Works in an S Corp: A shareholder in an S corporation (and a member of an LLC taxed as S corporations) is required to annually adjust his or her basis in the corporation's stock in order to reflect the items of income gain, loss, deduction and distribution allocated to that shareholder. Distributions to the stockholder decrease the basis but retained earnings of the corporation increase it.
Compare to a C Corp: if a C corporation accumulates earnings within the corporation over an extended period of time, those accumulations do nothing to increase the shareholders' tax basis in their stock.