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.
