By The LLC Attorney Team
Feb 22, 2024A Limited Liability Company is a pass-through entity by default. This can be changed by filing the necessary forms with the IRS, e.g. Forms 2553, 8822-b, 8832, etc. These forms and their implications are covered below.
It’s important to understand these differences as companies are partly created for their tax benefits, i.e. you will hope to pay less in taxes with a company than you would without. Structured correctly, the tax savings should more than offset the cost to create and maintain the company. In these cases, the asset protection and privacy benefits are “free” so to speak.
Limited Liability Companies are the most flexible business entities for taxation. They provide benefits unavailable to Corporations, Limited Partnerships, Trusts, etc.
When you apply for an EIN the IRS provides a default classification which cannot be changed online. This classification depends only on the number of members.
Again, these default settings cannot be changed online. They are automatic when applying for an EIN and the IRS does not ask or allow you to choose otherwise. Your next question is likely “how can an LLC be taxed” and “how do I update my LLC’s tax status”, which we answer next.
An LLC can be taxed as a Sole Proprietorship, Partnership, S-Corporation, or C-Corporation. The first three are examples of pass-through entities with the last paying taxes at the corporate level. There are benefits and disadvantages of choosing each. Ultimately, the decisions rest upon the facts of your situation and are best determined in consultation with an accountant familiar with your circumstances.
This is the default classification for Single-Member LLCs and is only available to companies with one owner. In this case, business income is reported, or flows, onto your personal income tax return 1040. The profit or loss you report is combined with other sources of income and consolidated onto this form.
A single owner company may be taxed this way, or elect for S-Corporation or C-Corporation taxation. It cannot be taxed as a partnership as there are no partners.
A Multi-Member LLC is taxed this way by default. It is a form of pass-through taxation. Partnerships are generally at a lower risk of audit. The theory is partners are more likely to keep each other honest than if there is one owner who is tempted to run non-business expenses through the company, but the exact reason why remains an open question for tax professionals.
The LLC itself files an informational Form 1065 simply reporting its taxable income for the year. If you are the owner of an LLC taxed as a partnership, you will receive a K-1 form from the company to report on your taxes. This is your share or portion of the company’s reportable income and you must pay taxes on it. The company does not do this on your behalf.
A company with multiple owners may be taxed this way, or elect for S-Corporation or C-Corporation taxation. It cannot be taxed as a Sole Proprietorship as there are partners.
This is yet another form of pass-through taxation. These were most popular prior to the advent of LLCs when Corporations wanted to avoid double taxation. Many tax professionals still like them because of familiarity, but this section of the IRS code some professionals view as antiquated as the benefits can be obtained elsewhere with less effort.
The benefit to this status is the ability to bifurcate earned and unearned income, meaning only a portion of the income will be subject to FICA taxes. This reduces your overall tax burden.
There are rules surrounding S-Corp taxes, such as all owners must be US residents and there cannot be more than one hundred owners. For additional clarity on eligibility and potential benefits, please contact a tax professional. Note, this election is made by filing Form 2553.
Few know a Limited Liability Company can be taxed as a Corporation. Why would you want this? The simplest reason is because you want corporate taxation without the disadvantages of running a corporation. That is, you don’t want convoluted share classes, a board of directors, share subscription agreements and other mandatory compliance. This is especially convenient when you are a single-member and the layers of accountability are simply bureaucratic. You may file a Form 8832 for this election, the company will then file Form 1120.
Some believe because their company is taxed as a sole proprietorship they lose their asset protection benefits. This is untrue. This classification simply refers to their tax designation. It doesn’t affect the other aspects of the company. For that reason, we don’t hesitate to recommend Limited Liability Companies even when there is a single member.
The default, as covered above, is partnership taxation with S-Corporation and C-Corporation being available options, too. While partnerships, such as LP, LLP, and LLLPs have their place, most often an LLC is the preferred option given the relative simplicity of the operating agreement versus drafting a custom partnership agreement.
The addition of a manager can affect the tax treatment of the members. For example, a non-managing member is not actively involved in the company’s daily affairs. Certainly, they vote and can assist with strategy, but they are not necessarily active within the company. For that reason, non-managing owners can speak with their accountants about declaring their income unearned. This yields similar benefits to an S-Corp designation, without the added complexity.
Non-residents of the United States face additional filings when conducting business in the US. The most common is Form 5472 which requires the disclosure of transactions with related parties. The form was previously only required for Corporations, but as of 2017, the requirement was extended to non-resident owned LLCs.
According to Treas. Reg. 1.482-1(i)(7), a reportable transaction also includes any sale, assignment, lease, license, loan, advance, contribution, distribution, disposition, or any other transfer of any property, whether tangible, intangible, real, personal, or money. The performance of any services for the benefit of, or on behalf of, another taxpayer may also qualify as a reportable transaction.
It’s important to understand what can and cannot be written off. It provides tax savings along with helping prevent or succeed if you’re audited. The short definition is that a cost incurred as a part of doing business qualifies, but that’s so vague as to be unhelpful.
Common expenses include rent and utilities for your office, this includes a home office, but the rates must be market or reasonable rates. A tax professional is best for this item as having a home office acts as a red flag to auditors given they’re prone to abuse. This isn’t to say don’t claim it, just be cautious.
Wages and salaries for employees are obviously defensible, but if you employ your children, then make sure they’re actually qualified for and performing the job. You can pay your teenager to lick envelopes, but they probably shouldn’t have a $50,000 salaried position as a delivery driver before they have their license.
Supplies, materials, travel, computers, insurance, and more are needed to perform business. Though, before you write them off, ask yourself whether this is really a personal expense and something you’re trying to “slip through”. Again, a CPA or tax professional should act as your source of truth for what is and isn’t allowed to avoid troubles with the Internal Revenue Service.
Commonly used tax software and services include but are not limited to, TurboTax, H&R Block, FreeTaxUSA, and more. However, we recommend using a local bookkeeper or accountant to ensure you take advantage of all available deductions. This is something even guided DIY software cannot as easily guarantee, which can cost you thousands in tax savings while depriving you of valuable business intelligence about your company.
Sales tax was previously easier to avoid, especially for online companies, but enforcement has recently been improved and there are no longer any loopholes. If you are present in a state, then you must collect sales tax on sales to residents in that state.
In states where you aren’t present, there are generally thresholds for when you must begin collecting. These average around $50,000 in sales or 200 transactions, but each jurisdiction is different. For example, New Mexico collects taxes on not only goods, but services as well.
We don’t consider tax benefits to be loopholes. Congress wrote the tax law to be intentionally beneficial toward small businesses. This encourages small business creation because they are the largest employers in the country. The United States is business friendly and you should take advantage of the laws where you can as they were written. Minimizing your taxes is not a loophole.
If your company is a pass-through business, then your rate will be determined by where you live, not where the company is formed. Those who form in Delaware or Wyoming thinking they can reduce their California taxes are mistaken. Taxes are determined by your personal residency. Thus, your tax rate will be determined by your personal income bracket for the state you live in with the federal rate being determined by the IRS.
Unless the company is taxed as a Corporation, the company does not pay its taxes. It may file an information return with the IRS, but the taxes are due by the members. The tax liability of the LLC "passes through" to the individual members, who report their share of the LLC's profits or losses on their personal tax returns and pay taxes accordingly. This flow of tax responsibility from the LLC to its members is a key characteristic of pass-through taxation, the default taxation method for LLCs.
In conclusion, understanding the taxation options for your LLC is essential for maximizing tax benefits and minimizing liabilities. From pass-through entities to corporate taxation, each option has its advantages and considerations. Consultation with a tax professional is recommended to navigate these complexities effectively. For inquiries regarding the formation of your LLC, please complete our contact form.