It’s no surprise that LLCs remain an attractive option for business owners. In addition to providing them limited liability, they allow the owners to customize the LLC’s management and economic structure while offering a high degree of flexibility in taxation. However, when organizing LLC formation documents, choosing the right federal tax structure is key.
Available federal tax options depend in part on the number and makeup of the LLC’s members. The options include: partnership, disregarded entity, C corporation, or S corporation.
Prior to 1997, an LLC was taxed as a corporation if it exhibited more than two of the following four corporate attributes: (1) continuity of life, (2) centralized management, (3) limited liability, and (4) free transferability of interests. To simplify the LLC’s determination of federal tax classification, the 1997 “check-the-box” regulations allowed partnership taxation to be the default classification for LLCs with two or more members.
Partnership Tax Regime
In a partnership tax regime, all of the company’s income, gains, losses, deductions and credits flow through to the individual owners who typically report their business income on Schedule C of their personal income tax return. Benefits of partnership taxation include:
- Avoiding double taxation of income and capital gains from the sale of the company’s assets.
- Allowing LLC members to use business losses to offset income, reducing their personal tax liability.
- Offering flexibility with respect to allocations and distributions of partnership tax items.
- For basis purposes, a member in an LLC classified as a partnership generally includes in basis not only the amount of capital contributed by the member, but also the member’s share of LLC liabilities.
These benefits do come with a price, including complex accounting requirements and complicated IRC partnership taxation rules.
Disregarded Entity
The default tax treatment of a single-member LLC is a disregarded entity. Sole proprietorships are “disregarded” for tax purposes and pass all tax items through the entity to be reported on the owner’s personal income tax return. Benefits of disregarded entity tax treatment include:
- Avoiding double taxation of income,
- Allowing the LLC owner to use business losses to offset income, thereby reducing their personal tax liability.
- Providing flexibility in allowing the LLC owner to use company assets.
The default tax treatment of an LLC owned solely by spouses depends on whether the LLC was formed in a community property state or a separate property state. In a community property state, if the LLC is a “qualified entity,” then the IRS will respect the owners’ desired tax treatment of the entity as either a disregarded entity or partnership. In a separate property state, an LLC owned solely by husband and wife must file as a partnership.
S Corporations
Like partnerships and sole proprietorships, S corporations are pass-through entities, but must comply with more rigorous statutory requirements to qualify for and maintain the S election. With requirements met, S corporations can take advantage of certain statutory tax benefits not available to other pass-through entities. For example, S corporation owners can be paid a “reasonable” salary (a deductible expense for the company). Any company profits in excess of the salary are treated as dividends rather than earned income and therefore are not subject to self-employment tax. By contrast, LLC profits are treated as earned income and LLC owners generally pay self-employment tax on all LLC profits.
There are some tax disadvantages of an S corporation. Because an S corporation must allocate profits and losses on a pro rata basis, the ability to deduct pass-through losses may be more limited. Additionally, there are several statutory requirements for S corporations that do not apply to LLCs taxed as partnerships. S corporations must have 100 or fewer owners consisting of individuals, certain trusts and estates. No non-resident alien owners, partnerships or corporations may own an S corporation. Additionally, only one class of stock is permitted. An LLC taxed as an S corporation can, however, have voting or non-voting interests.
C Corporations
C corporations are not pass-through entities. The tax items of C corporations are treated as tax items belonging to the corporation as a separate taxpayer, meaning the corporation’s income is taxed at the corporate level for the year in which the income is earned. When the corporation later distributes dividends to the shareholders, those shareholders must pay taxes on those distributions for the year in which the distributions are made – sometimes referred to as “double taxation.”
The flexibility of LLCs with respect to management, economics and taxation are appealing to business owners, but formation success requires close collaboration with an estate planning practice. As a result, small business law firms, CPAs and other advisors can add a tremendous amount of value in counseling their LLC clients on the merits and drawbacks of selecting one taxation method over another.
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