How the Federal Government Taxes LLCs

Alexander Davie

One of the benefits to using a limited liability company is the flexibility of being able to choose how the entity is taxed.  After a new LLC is formed, its owners must decide the method by which they would like their business taxed.  By default, an LLC is treated as a pass-through entity, which means that it does not pay federal taxes directly, but its income or loss is allocated to the owners, who then pay taxes on that income.  If the LLC has only one member, it files no tax return and all transactions of the LLC are treated as transactions of the owner for tax purposes.  If the LLC has more than one member, the LLC files a partnership tax return, which reports the LLC's income and how that income is to be allocated to each owner.  Partnership style taxation is governed by Subchapter K of the Internal Revenue Code.  However, the owner(s) of an LLC, whether the LLC has a single member or multiple members, may choose to have their LLC taxed as a corporation.  In this case, the LLC can be taxed as a so-called "C Corporation," which is governed under subchapter C of the Internal Revenue Code, or an "S Corporation," which is governed by Subchapter S.  This ability of LLC owners to elect the company's means of taxation is called the "check the box" regulations. Below are the summaries of the four methods of taxation of an LLC:

  • Disregarded Entity - This is the default rule for any LLC that has only one member.  The LLC is treated as though it did not exist for tax purposes and the owner were running a sole proprietorship.  All transactions - income and expenses - are included on the owner's tax return.  Therefore, no separate tax return need be filed for the LLC.
  • Subchapter K (aka partnership taxation) - This is the most flexible form of taxation for a multi-member LLC.  All income and losses of the LLC is allocated to the owners, who pay taxes on that income regardless of the amount of cash they received from the company.  A distribution of cash to owners is itself a tax-free event.  The owners of the LLC can be compensated for service to the company (called "guaranteed payments") in which case the payments are treated as an expense to the partnership and income to the owner.  Subchapter K is quite flexible, and allows the owners to allocate the income between themselves in a variety of ways, sometimes in quite complex formulas (subject to certain limited restrictions in the Internal Revenue Code).  One downside to using a partnership taxation structure is that the income of the partners is generally subject to the self-employment tax.
  • Subchapter C - If an LLC elects to be taxed under Subchapter C, it is treated for tax purposes, as if it were a corporation.  The company must file a corporate tax return (regardless of whether there is one member or multiple members) and the LLC itself pays taxes.  Any income that is paid to owners in the form of dividends is also taxable income to the owner (so-called "double taxation"), though the dividends are taxed to the owner at the capital gains rate.  Because of this, many C Corporation owners pay themselves a salary or bonus.  Such income is deductible to the corporation, though the compensation must be "reasonable."  If the IRS deems that the salaries paid to owners is higher than what would be reasonable if that owner was just an ordinary employee, it can reclassify part of the salary as a constructive dividend, subjecting the company to additional taxes and potential penalties.
  • Subchapter S - If an LLC elects to be taxed under Subchapter S, it is treated for tax purposes, as if it were a corporation that had elected to be treated as an S Corporation.  In this form, the company will still file a corporate tax return but does not itself pay taxes.  Instead, each owner is allocated a portion of profits or losses based on the percentage interest that they each own.  As in a partnership, the owners must then pay the taxes themselves, regardless of whether any cash has been distributed to them.  Any cash payments to owners (called distributions or dividends) are tax-free.  Active owners are considered employees of the company and can also be paid for their services to the company in the form of a salary or other payments, in which case, the payment will be deductible to the company and will be taxable wage income to the owner.  The benefit of taxing an LLC as an S Corporation is that income that is not paid out as a salary is not subject to self-employment taxes.  However, the IRS can scrutinize the salaries paid to owners and if they deem that the owners have been underpaid, they may reclassify some of the income as wages, subjecting the LLC and the owners to additional payroll taxes and potential penalties.  Another disadvantage to using Subchapter S is that the designation is very "fragile." There are a number of requirements the company must adhere to (such as having only one class of stock and no more than 100 owners).  If the company fails to adhere to these requirements, it will automatically be converted to a C-Corp and face double taxation.  The single class of stock requirement is especially easy to violate inadvertently.  If the LLC gives any owners preferred distributions or distributes distributions in any way except through a straight pro rata method, it could be deemed as having more than one class of stock.  In addition, many of the default provisions in LLC statutes violate the single class of stock requirement, which means that the operating agreement of an LLC taxed under Subchapter S must be carefully written to override the default provisions.

As you can see, there are many factors to consider in choosing how to have an LLC taxed.  Your final choice should be based on your own specific situation.  Therefore, before making any decisions on your form of business, you should speak with your attorney or accountant.

Read more articles by Alexander Davie at Strictly Business, a business law blog for entrepreneurs, emerging companies, and the investment management industry.

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