By Anthony Diosdi
Probably one of the most frequent questions any tax professional receives from his or her clients is how should my limited liability company (“LLC”) be taxed. As usual in any area of tax planning, there is no one-size-fits-all approach. Each individual’s circumstances must be carefully considered in determining how an LLC should be taxed.
An LLC is an entity formed under state law. Once an LLC is formed under state law, a determination must be made for federal (and in some cases for state tax purposes) how the LLC will be taxed. The Income Tax Regulations typically treat an LLC that has a single owner as a “tax nothing.” This means that a single-owner LLC is disregarded for tax purposes and treated as an extension of its owner. However, an LLC with at least two members will be classified as a partnership for tax purposes unless an appropriate election is made. The owner or owners of an LLC may elect out of being taxed as a disregarded entity or partnership and may elect to be taxed as a corporation. The owners of an LLC may elect to be taxed as a C corporation or an S corporation.
An LLC taxed as a C corporation is subject to double taxation. Earnings are taxed once at the “corporate level” when earned and again when distributed as dividends to the owners of the LLC. On the other hand, LLCs taxed as disregarded entities, partnerships, or S corporations are all considered passthrough entities. This means that for federal tax purposes there is only one level of tax. Tax is paid by each owner or member of the LLC on his or her personal income tax return.
In deciding whether an LLC should be taxed as a disregarded entity or an S corporation, the owner of the business enterprise should take into consideration whether he or she should be classified as an “employee” of his or her wholly owned LLC. For filing purposes, a disregarded entity does not file a separate tax return. Instead, the owner of a disregarded entity reports the income and expenses on a Schedule C of his individual income tax return. Individuals that operate an LLC that is taxed as a disregarded entity should understand that income of the business is subject to self-employment taxes. The self-employment tax is 15.30 percent of income. This consists of 12.40 percent Social Security tax and 2.9 percent for Medicare tax. Fifty percent of the self-employment tax is deductible by the owner of the LLC. After $147,000 of income, the Social Security tax is no longer assessed and only the 2.9 percent Medicare tax remains.
For example, assume an individual in the 24 percent tax bracket has an LLC that is treated as a disregarded entity. Assume further that the LLC had gross revenue of $100,000. For purposes of determining the federal consequences of the LLC, the $100,000 is subject to self-employment tax, resulting in a tax of $15,300. (15.30 x $100,000 = $15,300). Fifty percent of the $15,300 self employment tax is deductible. Therefore, taxable income in this case is $92,350 ($100,000 – $7,650). Applying the 24 percent tax bracket to the $92,350 taxable gain would result in a federal income tax liability of $22,164 (24% x $92,350 = $22,164). The total tax paid between self-employment and individual rates is $37,464 ($15,300 + $22,164= $37,464). Therefore, for taking into consideration federal income and self-employment taxes, the LLC owner will retain $62,536 ($100,000 – $37,464 = $62,536) of the original $100,000 earned.
As discussed above, an LLC can also be taxed as an S corporation. Eligibility to make a Subchapter S election is discussed in Internal Revenue Code Section 1361(b). Only a “qualified” entity may qualify for S corporate tax treatment. In order to be classified as a “qualified” entity, LLC must:
1. Have no more than 100 shareholders;
2. The LLC can only be individuals, estates, and certain types of trusts, and tax-exempt organizations;
3. The LLC cannot have any alien shareholders; and
4. The LLC cannot have more than one class of stock.
In certain cases, electing to have an LLC taxed as an S corporation may offer an opportunity for tax savings. A single member LLC that has elected S Corp tax status must pay “reasonable compensation” for services the member renders to the LLC as an employee. The compensation paid to a member is a deductible business expense of the LLC. The LLC treats the member’s reasonable compensation as ordinary income (W-2 employee treatment) and pays the necessary withholding taxes. Social Security withholding is required on all wages up to $147,000 in 2020. This level is called the Social Security Wage base. The employer and the employee each pay half of the Social Security tax. Each pays 7.65 percent for the total of 15.30 of wages up to $147,000. Wages over the wage base are not subject to Social Security Tax but are subject to Medicare (a total of 2.9 percent combining the employee and employer portions) with no ceiling.
In addition to his or her compensation, an LLC member is required to report and pay taxes on his or her pro rata share of the S corporation taxable income. This necessitates that the S corporation LLC file a separate tax return for the LLC and issue a K-1 to the member (which provides the amount of the distribution to the member to be included on the member’s individual income tax return). However, the pro rata distribution is not subject to self-employment tax. Unlike with a disregarded entity, an LLC taxed as an S corporation can allocate a portion of the entity’s income to wages subject to employment tax and a portion of the LLC’s income to distributions not subject to self-employment taxes.
In revisiting the above example, let us assume that the LLC has made a valid S corporation election. The LLC had $100,000 of gross revenue for the taxable year. The LLC pays the member employee reasonable compensation of $40,000. The remaining gross revenue, after paying necessary business expenses, is distributed to the single member. The owner and employee of the LLC pays his or her share of Social Security Tax and Medicare tax from his or her salary. This amount is $3,060. ($40,000 x 7.65 = $3,060). The employer or the LLC also pays Social Security tax and Medicare tax of $3,060. The LLC also pays the maximum unemployment tax of $420 (6 percent of the first $7,000). In this case, the LLC or employer would receive a deduction for the total Social Security tax, Medicare tax, and unemployment tax it has paid in the amount of $3,480. ($3,060 + $420 = $3,480). Therefore, the remaining $60,000 of gross revenue is then reduced by $3,480 resulting in $56,520 being available for distribution to the owner member. The owner member would report gross income of $96,520 ($40,000 + $56,520) on his or her personal income tax return. The owner member’s gross income is taxed at a 24 percent personal income tax rate resulting in income tax of $23,164.80. The total federal taxes paid on the wages and distributions is $29,704.80. After paying those applicable taxes, the LLC owner retains $70,295.20 ($100,000 – $29,704.80 = $70,295.20) of the original gross revenue.
In comparing the two examples of the net proceeds received by the member, there is a $7,759.20 benefit to the individual making the S corporation election for the LLC. This is assuming a 40/60 split between income subject to self-employment tax and distributions not subject to self-employment tax. The ability to make such an allocation may vary on a case by case basis.
The Check-The-Box Regulations
Under the check-the-box” regulations, a business entity that is not automatically classified as a corporation under Treasury Regulation Section 301.7701-2 is considered an “eligible entity.” An eligible entity with two or more members can elect classification as either an association taxable as a corporation or a partnership. An eligible entity with a single member can elect classification as an association taxable as a corporation or to be disregarded as an entity separate from its owner. See Treas. Reg. Section 301.7701-2(a). Presumably, most business entities will prefer the pass-through treatment to the double taxation of Subchapter C corporations. Consequently, the regulations provide a default partnership classification rule- if no election is filed for a domestic entity with two or more members, the entity will be treated as a partnership. Similarly, since it is presumed that most individual owners will prefer to avoid Subchapter C double taxation, a default rule provides that if no election is filed for a domestic single-owner entity, the entity “will be disregarded as an entity separate from its owners.” See Treas. Reg. Section 301.7701-3(b)(1).
Since the default rules are explicit, the regulations clarify that “actions are necessary only when an eligible entity chooses to be classified initially as other than the default classification or when an eligible entity chooses to change its classification.” In other words, an entity that wishes corporate tax status must make a formal election; other entities need do nothing.
Although taxing an LLC as an S corporation may offer some federal tax benefits. The drawback of making such an election is the increased administration. An LLC taxed as an S corporation is required to administer payroll, file quarterly withholdings, and pay unemployment insurance (State and federal). In addition, an LLC taxed as an S corporation must file its own tax return, make distributions, and issue at least one K-1. In deciding between being a disregarded entity or an S Corporation, a business owner should carefully consider the potential tax savings against the additional administrative costs.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony Diosdi focuses a part of his practice on criminal tax enforcement, broad-based civil tax compliance and white collar matters generally. He also advises clients on the IRS voluntary disclosure program, with particular focus on disclosure related to offshore banking accounts.
Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: email@example.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.