Keeping up-to-date on how limited liability companies (LLCs) are taxed will help you take full advantage of opportunities as they arise and avoid lesser-known pitfalls and common misconceptions associated with LLCs. Tax laws that govern LLCs are prone to change on a fairly routine basis. Understanding these changes and how they affect your company can help you determine which classifications and practices to implement, and when you may need to seek expert tax and legal advice. Find out more about forming a Colorado LLC, registered a Colorado business and our registered agent services.
The IRS classifies LLCs as pass-through entities. The pass-through classification signifies that a company’s tax liabilities are passed on directly to the personal tax return of the owner or partners of that company. In other words, the owners record the company’s profits and losses directly as their own.
It’s important to be aware of certain pass-through taxation specifications, as there are common misconceptions associated with the classification. Some think forming an LLC in a state like Wyoming that does not have income tax will free them up from having to pay income tax. But this is not the case. Income tax applies based on where the owner lives, not simply where the owner formed the LLC. So, if the LLC owner lives in Iowa, for example, then it is Iowa’s income tax rate that applies, even if the company is incorporated elsewhere.
Due to their pass-through entity status, LLCs can bypass double taxation. Double taxation occurs with corporations because the IRS considers them separate legal entities from their shareholders. However, LLCs avoid this, as the IRS treats them like sole-proprietorships or partnerships.
Disregarded entities and partnerships are the two main distinctions within the IRS default classification. If your LLC has a single owner, it receives disregarded entity classification. Whereas, if your LLC has multiple owners, it receives a partnership classification. In the case of a partnership, additional annual reports must be filed with the IRS to ensure accurate reporting of earnings.
Enlist the service of an accountant to learn which is best for you or if your current classification is in need of an update to better reflect your situation.
Using an LLC for wealth planning and investment can offer flexibility and opportunity to families, should they understand the rules that govern these entities. In addition, many find that the LLC structure provides their family with effective means for financial planning and goal-setting, and in this sense use their LLC as a wealth-planning tool.
When difficulties arise with gifting assets, such as dividing up fractional interests of businesses or real estate, LLCs offer a unique solution. With an LLC, it is possible to gift fractional interest, much like shares of a stock, that represent the LLC’s assets as a whole. Each associated member would own a percent of the underlying value.
There are limits in place for gifts with an LLC. $13,000 is the annual limit on gifting that can occur before paying gift tax for a single recipient. If it is a joint gift made by spouses, the amount is $26,000. So, if a couple had three children, for example, the total amount that the couple could gift their children in a year without gift tax would be $78,000.
LLCs can offer additional protection when it comes to gifted interests. Depending on the agreements reached by members, it is possible to put restrictions on transferring LLC units outside of the LLC. Additionally, restrictions help secure the overall structure and underlying assets of the LLC from outside creditors, divorce proceedings, and any other wasting or spending concerns that can occur with cash or property.
When given as gifts, fair market value determines the LLC unit value. This value corresponds to the acceptable price that either party, buyer or seller, would agree upon given that both parties have knowledge of the relevant facts and an unpressured willingness to buy and sell, respectively. With this in mind, when the LLC’s underlying assets are less than fair market value, the gift donor may be able to transfer greater value in LLC units.
There are a few different ways of obtaining profits from your LLC. Your own method will depend on the tax election your LLC made with the IRS. One such way is by declaring distributions, which allow members to receive an amount proportional to the number of shares they own, otherwise known as a pro-rata dividend. Another way is through the LLC paying salaries to its members through use of management fees. Also, LLCs can offer loans to members that match market interest rates. Finally, members can use paid distributions to buy additional LLC units, which reduces the taxable estate of the owners and provides them with a cash source.
In some cases, LLCs may provide an opportunity for savings in income tax. If certain members are of a lower tax bracket, income shifting to those members may achieve this. Additionally, there are instances where savings in franchise tax are achievable with LLCs, but it relies heavily on jurisdiction. Considering state law is important for both franchise and income tax as it pertains to your LLC.
Enlisting the services of a CPA for LLC planning, formation, and compliance is a smart choice. A CPA will be up-to-date on tax and compliance matters and can also offer guidance in structuring a comprehensive estate plan. Tax and legal fees, as well as fees for estate planning often are tax deductible and have the option to be amortized, beginning with the LLCs inception date. Additionally, consider a CPA when filing the LLCs federal income return for assurance of proper preparation and compliance. This process involves complex accounting and can require expert tax and legal advice to determine how federal and state securities law applies, as well.
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