I originally posted this blog article in November, 2010. But I find that even over a decade later, many business owners – and their professional advisors- don’t understand how a Limited Liability Company is viewed under U.S. and state tax laws. Here’s a quick reboot of this important information, and an invitation to reach out to us if you need help with your business and tax strategy.
It doesn’t seem like that long ago that I was steering clients away from LLC’s, only because the case law hadn’t been established and I didn’t like my clients acting as Guinea Pigs for something that was relatively new on the scene. That was quite awhile ago, and LLC’s have gained in popularity and most of the legal aspects have been hammered out by state statute and IRS regulations.
The first U.S.-based law allowing the establishment of LLC’s was the Wyoming LLC Act in 1977. In 1980, the first LLC established under the Wyoming statute had to request a Private Letter Ruling from IRS to determine how the business would be taxed. At that time, IRS said it would treat the LLC as a partnership for federal tax purposes.
This is still the default tax structure for a multi-member LLC today. However, I find that many clients and associates – and their advisors – don’t understand that the default structure, also known as “disregarded entity” isn’t the only option, and in fact, may not be the best option for the client.
Many people also don’t realize that an LLC is created under state law, and by itself is not a tax-structured entity. For that reason, as your tax advisors, we typically need to dig a little deeper into the LLC if we didn’t help in setting up your business to make sure the correct tax forms are being filed and to verify that it’s the best structure for your situation. We have seen several occasions where the wrong tax forms were used for the LLC’s tax return. This can create problems where none should have existed, just by virtue of the wrong tax return going in to IRS.
Under current U.S. Tax Law, the default tax structure for a multi-member LLC is as a partnership and for a single-member LLC the default tax structure is generally as a sole proprietorship. Single-member rental real estate LLC’s use Schedule E of the member’s 1040. While the LLC structure does provide the limited liability aspects of a corporate structure without many of the required formalities and filing, the default tax structures usually don’t offer much benefit to a non-rental real estate LLC. In these instances, the net income from the LLC is reported on the member’s individual tax return either on Schedule C (single-member) or from schedule K-1 (multi-member) and then is subject to self employment tax at 15.3%.
Depending on the goals and tax situation of the member(s), the owners of an LLC may want to consider electing to be taxed as a corporation. This is a simple one-page election process that is filed with the IRS, and grants the LLC the best of both worlds: limited liability through the LLC and tax-advantaged planning and benefits of a corporation. The corporation election can either be as a traditional C-corporation, where the corporation itself is taxed on net income, or as an S-corporation, where the actively participating members are paid a reasonable salary for services, subject to payroll taxes, and the net profit flows through to the members’ individual tax return as ordinary income not subject only to income taxes, but not to FICA, Medicare and unemployment taxes.
It’s important to plan the aspects of your LLC in harmony with the rest of your tax strategy and situation. Our clients get unlimited year-round consulting to make sure this happens and there are no unwanted surprises at tax time. Let us know if you’d like more information on how we can help you stay ahead of the game.