LLC owners have four distinct tax options for their LLCs. Knowing which road to take may have a huge impact on your income tax liability.
LLCs are definitely the rage. My majority of my business insurance clients in Minnesota, Michigan, and Wisconsin are using a Limited Liability Company (LLC) entity structure. The first decision to use a separate entity is usually the correct one. That's good compared to the unlimited liability and financial exposure sole proprietorships or partnerships have, but it's only one and the first piece of the financial puzzle. As a LLC owner, you also decide how the government should tax the LLC.
However, when asked, most haven't given much thought or even know choices are available. Similar to corporations, an LLC is a custom entity created by state law and the IRS allows for custom tax treatment. Here are four tax choices for your LLC:
Single-Member LLC treated as a "disregarded entity"
A single-member LLC is taxed as if it's a sole proprietor. In order to qualify, the LLC can only have one owner (a husband and wife may or may not be one owner depending on how you setup the LLC). In tax terms, it's treated as a Pass-through entity, and the LLC doesn't pay taxes, the owner claims the income (regardless if they take any money or not) on his/her tax return, The income (or loss as the case may be) is reported on Schedule C of the owner's personal tax return.
Self employment taxes depend on the type of activity generates the income. For most single member LLC's, the owner is providing goods or services that can range from accounting to zoo veternarian services. If your LLC is providing goods and services, the income is subject to FICA (social security) "earned income"/ employment taxes.
If your LLC is an investment vehicle, for example invests in stocks, real estate, and other passive types of activities, then employement taxes are not likely paid on the income.
Multiple-Member LLC – similar to Limited liability Partnership (LLP)
If an LLC has more than one member/owner, it will be taxed in the same way as a partnership (you should also look up LLPs if your considering a multiple member LLC). Each owner/member pays a proportion of tax (assuming it's profitable, and if not, then deductions are available) based on the profits of the LLC. This means the effective tax rate will vary depending on the tax rate of each owner. If and LLC with two owners, each with a 50/50 ownership makes $2 in profit. Then each owner will be taxed on $1 of profit.
If one partner pays an 25% overall tax rate based on his/her income, then 25% of that part of the LLC's income was effectively taxed. However, if the other partner pays a tax rate of 50%, then half the income is taxed at an effective rate of 50%, for a blended rate of 37.5%. But of course the LLC itself doesn't pay the tax, the owners do after receing the form 1065 partnership tax information. Employment tax works the same way as a single-member LLC.
LLC with C corporation tax treatment
One innovative strategy that small business owners often fail to consider is electing tax treatment as if it the LLC was a C corporation. A C corporation is your standard "old school" corporation where it acts as a separate entity in every way, including taxes. A C corporation files it's own tax return, and distributes profits to shareholders by declaring dividends.
Dividends paid are not tax deductible for C corporations or LLCs operating under C corporation tax treatment, so the income earned by the LLC/corporation is taxed, and then the owners receiving dividends are taxed for receiving dividends. This is where the term "double taxation" comes from because the income is taxed twice.
Despite the double taxation problem, often C corporate tax treatment is advantageous. By having a separate taxable entity, it's possible for owners to "dial in" how much personal income they receive in any given year, which is helpful for those on the "edge" of higher brackets and/or highly variable income streams. C corporation taxes start out low, but surpass individual tax rates quickly at the time of writing. Since tax rates, including marginal tax rates fluctuate non-stop (we have congress to thank for that), you'll want to speak with a tax advisor to get the current and expected rates to see how it impacts you.
LLCs file an IRS form 8832 and files a corporate tax return in order to take this election. While the LLCs income/profit aren't subject to self-employment taxes, C corporations pay the "employer's share" of self-employment tax on wages paid to officers and employees. The whole concept of "employer's share" of employment tax is a bit of a shell game, or maybe three-card-monte. Of course it's the wage earner paying it, but the government when setting up FICA/Social Security thought it was an easier sell to the public if the "employer" was paying "half". Make no mistake, if you're an employee, you're paying all of it, no different than if you're self employed.
LLC taking the S corporation election
S corporations became very popular when they became available. They are considered "pass-through" entities, and income flows through the LLC to the owners without the LLC paying taxes (as it would otherwise if treated as a C corporation). Think of the "S" in S corporation as "small", because the S corporation is designed for the smaller businesses. There are many rules concerning what ownership and other factors will allow for the S corporation elections and is beyond the scope of this article.
But after confirming your LLC is eligible for S corporation status, there's a very good likelihood that it may appear attractive to you for the same reason why they became so popular when first made available. The downside of a S election compared to the C corporation election is that all profits flow through regardless if any money is paid to the owners (as in the form of dividends). So it's very possible that an owner could pay tax on income that the LLC earned, but did not pay out to the owners.
The flipside is also true. A LLC with S corporation tax status could lose money, and the owners would get a deduction on their taxes. This makes S corporations especially attractive when a new business is starting out because it provides the owners with immediate tax benefits that C corporation owners don't enjoy.
Putting it all together
Like so many other tax issues, it's usualy worth the time and effort to investigate each option and try to detirmine which fits your business and personal objectives the best. If you're feeling overwhelmed with the possibilities, you're certainly not alone. It's the reason why there are so many tax advisors. It's also why I don't recommend trying to figure it out on your own. You'll spend way too much time trying to learn it all that is probably better spent building your business. You'll also risk making a mistake and wind up wasting your time and not get the results you desire.
I work with and know many tax advisors, so drop me a line and I will be happy to recommend one or more to you. And don't feel you have the hire the first one you talk to. It's always a good idea to interview more than one to make sure you're a good fit working together.
Lastly, if it's all too stressful and you just want to relax, The Body Focus massage is where I go to "shut off the world" for an hour.