Taxation of LLCs: More to Check Than A Box (Post 2 of 3 on LLC Basics)

Arapahoe Basin Spring 2016.  Copyright, David C. Uhlig 2016.

     This is the second in a series of three posts concerning LLC basics; the first covered operating agreements, this one covers taxation and a future post will cover liability protection and piercing the corporate veil.

Depending on the entity, the irs taxes income and losses differently.

     Working with entrepreneurs in real estate and other realms is a lot of fun because it affords many opportunities to listen to the plans and ideas of creative and intelligent people and and assist them with making those plans a reality.  Almost daily, people call or sit down across from me and want to talk about creating an LLC.  The plans for the entity and experience of the clients vary. Sometimes, they are financially savvy and/or they’ve talked extensively with tax advisors in advance and have a solid understanding of LLCs, why that entity will work best for their purposes and exactly how it needs to be structured to reap the maximum benefit for them and their co-venturers.   Other times they haven’t thought about entity formation much beyond knowing they need one and they’ve heard that LLCs are a great choice from a tax perspective. To me, the first scenario is always preferable because while I can describe the different ways that various entities, including LLCs, will be taxed, I don’t purport to advise clients on the consequences the taxation regimes will have on the various members, partners or shareholders. When it comes to planning the structure of an entity, all but the most sophisticated clients are best served by working with a team of advisors which includes, at a minimum, an attorney, a business CPA and a financial advisor.  Depending on the entity chosen, income generated or losses incurred are treated differently for tax purposes. Let’s take a close look at how the IRS treats LLCs and some of the basic structuring options that are available to owners that choose to operate as an LLC.

     The IRS treats single member LLCs as disregarded entities.  The entity does not file a return. From a tax perspective, it’s as if the LLC doesn’t exist. As with a sole proprietorship, the member simply attaches a Schedule C reporting the profits or losses of the business to their individual tax return.  Unless the LLC elects to be taxed as a corporation, LLC income is passed through to the member and is taxed as his or her individual income. Unlike single member LLCs, corporations are treated as separate entities by the IRS.  As such, C corporation income is taxed at the corporate tax rate and when part of that income is paid to shareholders as wages or salaries, it is taxed again at the individual tax rates (unless the corporation is an S corporation); this is the infamous “double tax” synonymous with doing business as a C corporation.   So, if a single member LLC is taxed like sole proprietorship, which doesn’t require any formalities, why form and operate under an LLC?  Unlike with a sole proprietorship, the members of a properly organized and operated LLC are insulated from the debts and liabilities of the LLC.  For that reason alone, in most cases creating and operating as an LLC is worthwhile; certainly if there is any possibility of exposure to third party liability.

single member llcs are disregarded entities; multi member llcs are tax reporting entities but not tax paying entities.

     Unlike single member LLCs, the IRS recognizes multi member LLCs as reporting entities, like a partnership. They file a separate return, but the multi member LLC’s income or losses are passed through to the members rather than taxed to the LLC itself.  In common parlance; pass through entities such as partnerships, multi member LLCs and S Corps are tax reporting but not tax paying entities.  The pass through is accomplished by attaching Schedule K-1s to the LLC’s tax return describing each member’s pro-rata share of the LLC’s income. 

     One thing to bear in mind when evaluating choice of entity and whether an LLC is the best entity form for a business is that the most substantial tax savings realized by LLC members is often not on income taxes.  Individual and corporate tax rates are not widely disparate until income amounts are very high; that isn’t a problem commonly suffered by early stage companies.  More substantial tax savings can be realized by LLC members if the business expects long term capital gains or if it incurs losses.  The individual tax rate on long term capital gains is 15% for all but top earners.  Conversely, corporate long term capital gains are taxed at the corporate income tax rates: 15% on the first $50,000, 25% on the next $25,000, 34% on the next $25,000 and then 39% on the next $235,000.

     At the risk of stating the obvious, many startup companies and early stage businesses experience losses in their early years.  If an individual is a member of an LLC with losses and that person has other alternative sources of income, it may be possible to offset the LLC’s losses against that other income and/or completely eliminate income taxes otherwise due.  Each business and its principals have a unique equation so, it’s important to closely scrutinize choice of entity.  That being said, the advantages with respect to treatment of losses and of long term capital gains present a strong case for many early phase businesses to utilize an LLC instead of a corporation.

     At this point, you may be wondering ‘why not elect corporate taxation and file an S election so the business can utilize the corporate structure, benefit from a liability shield and obtain pass through treatment for income tax purposes?’  Additionally, S Corporations have an employment tax advantage. Wages and salaries paid to S. Corporation shareholders are subject to employment taxes, paid through withholdings, but not other S. Corporation income reported on a shareholder’s K-1.  The S. Corp can hold back income for reserves or capital acquisitions and avoid employment taxes on that corporate income when it’s distributed as dividends or when shareholders sell their stock.  Despite other tax advantages, LLC’s aren’t ideal when it comes to employment taxes.  All LLC income is treated as wages to the Members and as such it subject to employment taxes.  In 2016 the rate is 15.3% on net income up to $118,500.00 and 2.9% of the rest.   

s corporations are subject to several restrictions that dont apply to llcs.

     Still with me?  In summary, subject to exceptions based on circumstances and plans, an LLC is often better than a C corporation for early phase businesses but LLC’s do not enjoy, at least not readily, certain tax advantages enjoyed by S corporations, such as employment tax savings. S corporations also enjoy tax free reorganization benefits that are especially attractive in certain acquisition contexts.  If you are thoroughly caffeinated, you may now be wondering why one would consider an LLC when it’s possible to obtain pass through taxation and employment tax advantages by incorporating as an S corporation.  The short answer is, it’s not that simple!  S corporations have several disadvantages, mostly in the form of restrictions, that LLCs do not suffer from.  To name a few big ones: S corporations may only have a single class of stock; unlike LLCs, S corporations can’t use special allocations to assign disproportionate losses (or gains) to certain shareholders that may want those losses; and likewise, S corporations must distribute their income pro-rata, according to share ownership.  This last restriction, when combined with the first, makes preferred returns very difficult.  In short, S corporations afford many of the same benefits as LLCs, as well as some notable extras such the employment tax advantages, but they are much less flexible than LLCs from a structural standpoint. At some point, I’ll do a post examining the relative advantages and disadvantages of S corporations, but, sticking to the theme, LLC basics, there is a final twist:  LLCs, even single member LLCs, may elect corporate taxation, then file an S Election and thereby enjoy the employment tax benefits of the S. corporation structure! 

     When an LLC makes an S election it agrees to play by the S corporation rules.  That can be a non-starter for many businesses; it’s a decision that should be carefully evaluated.  An LLC that elects corporate taxation may not change back for 5 years and then must wait 5 years before it may again elect corporate taxation (i.e., a company cannot pick and choose based on how any given year is going).  Further, changing back to an LLC is treated as a liquidation which can be a taxable event.

     This blog only scratches the surface, the waters become deeper and murkier fast.  There are many nuances that are not addressed here in the interest of sticking to the theme.  Ideally, when working with clients on choice of entity matters, its best for attorneys who are not tax specialists (such as myself), to work with a team comprised of a business CPA and/or a financial planner, at a minimum.  While most business attorneys should understand and be able to explain the basic tax methodologies applicable to different business entity forms, a CPA or tax specialist should consider and advise clients on all the nuances and how they impact a particular client’s overall financial picture.  Thanks again for taking the time to read the Summit 6 Legal blog.