FOUR WAYS A LIMITED LIABILITY COMPANY CAN BE TAXED
With the onslaught of LLC filings, I find it very interesting that most people forming a limited liability company have no idea they have a choice on how their LLC can be taxed. In fact, I can say with certainty that the majority of them are paying more than their fair share of taxes and have left themselves with very little opportunity to significantly reduce their taxes.
I also know that a lot of tax professionals advise against forming an LLC because they don’t see the advantages and tell their clients it’s just more paperwork for them if they do. I don’t want to get off track on that conversation because frankly, it demonstrates that most people have no idea whether they’re getting good tax advice or not – and in this case it’s not.
As a business owner,
- anytime you can separate yourself from your business’ debts, liabilities and obligations it makes sense to use a structure like an LLC
vs. not having an entity when you operate as a sole-proprietor. If for no other reason than liability protection, it certainly makes sense to operate from an LLC.
Your decision to form an LLC also needs to include a discussion about how you want the LLC to be taxed. We have saved our clients thousands of dollars in unnecessary taxes simply because we took the time to explain that they actually have a choice as to where all of the tax liability is going to land. Simply put, do you want to pay Uncle Sam from your personal checking account or from your business checking account? The following will explain why?
SINGLE-MEMBER LLC
Many LLCs, such as those formed for a simple home-based business, are structured with one owner. For federal income tax purposes, these LLCs are ignored, the term used is “disregarded entity”. If you have a business, you will report the income or loss from the business on your personal tax return, Form 1040, Schedule C. If your single-member LLC owns a rental property, that income or loss will be reported on Schedule E. The income taxes paid are based on your individual income tax bracket.
TWO OR MORE MEMBER LLC
The majority of all LLCs that have two or more members are characterized as partnerships for income tax purposes. Because LLCs do not pay federal income taxes, LLC income is taxed at a single level - to the members. Each year the LLC will file IRS Form 1065, U.S. Partnership Return of Income. LLCs annually issue each member a Form K-1, showing the member’s annual share of the business’s profit or loss which is reported on Schedule C of their individual income tax return.
This tax structure is ideal when you are earning passive income (rents, royalties, distributions). However, if you are actively engaged in a business and have earned-income (you earn it by providing goods and services to customers), this tax structure doesn’t make a lot of sense because you will be subject to self-employment taxes on your earned income.
LLC TAXED AS A CORPORATION
The IRS has made it possible for an LLC to be taxed as a corporation so that it can retain, instead of distribute profits to meet future business needs. The advantage is that a member will pay individual income taxes on only the profits actually paid to them through their W-2 wages. You essentially become an employee in your own company, subject to the federal and state withholdings on your wages. This means you pay your taxes as you go.
The business will file IRS Form 1120, U.S. Corporation Income Tax Return to pay taxes due on any retained profits at the reduced corporate tax rates.
The argument I hear all the time about this strategy is that a C corporation is subject to double taxation. The corporation pays taxes on any retained profits and then when it pays a dividend to the shareholders, the shareholders have to report and pay taxes on that distributed income on their personal tax return (hence double taxation). The maximum federal income tax rate on C corporation dividends is now only 15 percent (through 2010). So the double taxation of corporate earnings is not nearly as big a problem right now as it was before the 2003 law change when dividends were taxed at high ordinary income rates.
But my question, “Why in the world would you pay yourself dividends?” At Sage International, Inc. we teach people the benefits of knowing the difference between Advanced Tax Planning versus the status quo of merely tax compliance. This means that you understand and are doing everything possible to maximize the tax code to your advantage so that by year end, you have minimum or no taxes to pay!
An LLC taxed as a corporation offers tremendous tax advantages and tax-free fringe benefits to its employees. You have so many more options for taking cash or benefits out of the LLC besides issuing a dividend (salary, bonuses, commissions, loans, leases, sale of assets, employee benefits) that I cringe whenever I hear someone say, “MY CPA said I shouldn’t form a corporation because of double taxation!” And in this case, most don’t understand why you would form an LLC and have it taxed as a corporation. That’s such an old way of thinking and frankly, completely outdated advice.
LLC TAXED AS AN “S” CORPORATION
An LLC that elects to be taxed as a corporation may also elect S corporation status by filing IRS Form 2553. The main reason for this election is to eliminate self-employment tax on distributed income if you are operating an active business through your LLC versus passive activity.
With an S election all of the income from your business “passes through” to you and is reported on your personal tax return. Taking this election makes sense if you are going to
● experience losses in your business because those losses can offset other sources of income, or
● if the owners are earning less than $106,800 (2009); and
● you don’t need to retain any capital for equipment, inventory, advertising or marketing; and
● all financing will be provided by the shareholders; and
● you meet all the tests for qualifying as a Subchapter S Corporation.
Here’s how it works: You compute the corporation’s gross income and subtract any business deductions to arrive at the net taxable income. You then file an individual return on your pro-rata share of the corporation’s net income or loss. The S corporation would not pay any tax on the income.
The key to saving Social Security taxes is that with an S corporation you pay self-employment tax on wages, salaries, and bonuses but not on dividends. Your share of undistributed earnings is deemed dividends and not wages and is treated as an actual dividend distribution which is not subject to self-employment tax. So you pay yourself a little bit of salary and pay the rest in dividends if you want to wipe out most of your social security tax.
C Corp vs. S Corp COMPARISON
If you draw a salary (W2) from the corporation and pump all of your profits back into the business, you will come out ahead as a C Corporation because the money that remains in the business will be taxed at the lower corporate tax rate (15% on the first $50,000 of net earnings).
Example: The first $100,000 of annual corporate income is taxed at much lower rates than those that apply to high-income individuals. Specifically, the average rate on the first $100,000 of C corporation income is only 22.25 percent. If that same $100,000 was earned by an S corporation and passed through to you and the other shareholders, the tax hit would almost certainly be at higher rates probably 28 percent or more. If your C corporation’s annual taxable income is above $335,000, the company pays an average federal rate of 34 percent. That’s still one percentage point below the 35 percent maximum rate for individuals.
NOTE: If you elect to have your LLC taxed as a corporation, generally you cannot go back to flow-through taxation for a period of 5 years. The IRS can waive this limit if there has been a greater-than 50% ownership change in the LLC.
State Taxes on LLCs
In some states, like California, the LLC has to pay income taxes even though no taxes will be paid to the IRS.
Is An LLC The Right Structure For You?
Honestly, I don’t know because there are more issues to address before a decision can be made. What I do know is that a lot of people jump into an LLC without a clue if this is actually the right structure for them to accomplish the goals and results they desire. Before anyone forms a corporation or an LLC they should talk to someone (like Sage International, Inc.) to make sure all of the right questions are being asked and to make sure you have the ongoing support required long after the entity has been formed.
© Sept 2009 Sage International, Inc.