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Friday, November 7, 2014

Proper LLC Tax Election May Save Money

There are many factors that a business owner must consider when deciding whether to establish an LLC or a corporation.  (See YouTube video at: https://www.youtube.com/watch?v=_o2bPSaQRbI).  While both LLCs and corporations provide equivalent liability protection, LLCs have grown in popularity over the last decade, primarily due to the ease with which they can be organized.  In addition, unlike C-corporations, LLCs are not required to pay a separate corporate tax. 

Many business owners do not realize that an LLC can be taxed in a few different ways. In order to maximize the tax benefits of establishing an LLC, the business owner should choose the correct tax election in consultation with an experienced tax consultant.  This article is a basic summary of the different ways in which an LLC can elect to be taxed. This article is only an outline and any tax election decision should be made in consultation with an experienced tax consultant.

If the LLC does not make any tax election, then by default, a single member LLC will be treated as a “disregarded entity” for federal tax purposes, and a multi-member LLC will be classified as a “partnership” for federal tax purposes.  In such event, the LLC is not considered to be the “employer” of the member(s), and the member(s) are not considered to be “employees” of the LLC.  In lieu of the FICA payroll taxes that employees and employers of other business entities are required to pay, the members pay self-employment taxes pursuant to SECA in addition to their regular income taxes.

The LLC may avoid the default tax treatment described above if it timely chooses to be taxed as a C-corporation or as a Sub-S corporation.  (See http://www.irs.gov/publications/p3402/ar02.html).  While it does not usually make sense for an LLC to elect to be taxed as a C-corporation, since such election destroys one of the principle reasons for establishing the LLC (i.e. the avoidance of the corporate tax), it might make sense for the LLC to elect to be taxed as a Sub-S corporation.  The primary reason is that if the LLC elects to be taxed as a Sub-S corporation, then the members can be treated as employees of the LLC and pay themselves “reasonable compensation” as W2 wages subject to FICA payroll taxes (in lieu of SECA taxes).  The members can also pay themselves any remaining company profits as distributions.  In many cases, the SECA tax rate is higher than the FICA tax rate, and thus the members may save on taxes by establishing the employer/employee relationship. In addition, in most cases, the excess distributions from a Sub-S corporation to the members are not subject to FICA taxes or SECA taxes, and the members need only pay regular income taxes on such income.  Of course, the IRS carefully scrutinizers the tax treatment of sub-S corporations in order to prevent tax avoidance, and the sub-S election is not appropriate for all business owners.   

Another tax consideration for the business owner to consider is how the income, deductions, gains, losses and tax credits will be allocated to the members of a multi-member LLC.  The operating agreement of the LLC should specify this allocation.  (See YouTube video at: https://www.youtube.com/watch?v=DiLfBzKNAeM)  While the IRS gives the LLC flexibility for such allocation, it also imposes limitations to prevent an LLC from allocating disproportionate losses to high income earners for the purpose of offsetting income from outside sources.  A Sub-S corporation is required to allocate these items consistent with ownership percentages. The members are required to have a basis in the entity in order to deduct losses currently.

In order to maximize the tax benefits of establishing an LLC, the business owner should consult with an experienced tax consultant regarding tax elections and the tax provisions of the LC's operating agreement.  Generally, an election specifying an LLC’s classification cannot take effect more than 75 days prior to the date the election is filed, nor can it take effect later than 12 months after the date the election is filed.

For assistance in organizing an LLC, contact Gross & Romanick at 703-273-1400, or contact Edward Gross directly at law@gross.com. 

This article was edited by Thomas G. Jenkins, CPA, of Thomas Jenkins and Company, P.C., whose office is located in Camp Springs, Maryland.  Thomas G. Jenkins may be contacted directly at 301-423-4474.