Tax Implication of Forming an LLC
The LLC business structure has become one of the most popular entity types for small businesses. A few features that make it so attractive include its:
- Limited personal liability (protection of business owners’ personal assets)
- Ease of formation
- Flexibility in management and ownership
- Few ongoing business compliance requirements
- Tax flexibility
As you’re working with business clients who are considering forming an LLC, you’ll want to point them to the right resources to answer questions regarding the legal aspects of the LLC structure. And as a financial professional, you’ll want to offer them the insight they’ll need to make a wise decision from a tax perspective.
Key Points Clients Should Know About LLCs and Taxes
The information below isn’t meant as accounting or tax advice but rather a reminder of the talking points you may want to cover during your conversations with clients. Laying out how LLCs are taxed by default and the tax treatment options available to some LLC owners can help your clients weigh the pros and cons of the LLC structure for their particular situation.
Taxes and the Single-Member LLC
An LLC with one owner (“member”) is treated for tax purposes as a sole proprietor. This means that the business’s profits and losses flow to the owner’s individual federal income tax return. LLC owners must pay self-employment taxes (a total of 15.3 percent with Social Security and Medicare combined) on their taxable income from the business (unless the LLC is set up only for a passive activity, such as a real estate investment). Because LLC owners do not have taxes withheld on paychecks, they must make quarterly income tax payments to the IRS (and in states and local jurisdictions that levy income tax).
Taxes and the Multi-Member LLC
When an LLC has multiple owners (“members”), the IRS will, by default, tax it as a partnership. Profits and losses (usually in accordance with members’ ownership interests in the LLC) will pass through to the owners’ personal income tax returns. As with single-member LLCs, multi-member LLC owners must pay self-employment taxes on their taxable income (except profits from passive income) from the business, and they must make quarterly income tax payments.
Under some circumstances, LLC members may want to divide profits amongst themselves in a way other than according to their ownership percentages. For example, perhaps one member hasn’t invested as much money in the business as other members but has been putting in much more time in starting and running it. Members might agree that it’s fair to give that member an equal share or more of the the profits because of that person’s hard work. It’s important to confirm that an alternate profit allocation arrangement will be allowed by the IRS and state before assuming that the LLC structure will offer this degree of flexibility.
Tax Elections Available to LLCs
If an LLC meets the eligibility requirements, members may elect to have the company taxed as either a C Corporation or S Corporation. Of course, your clients would look to you to determine if one of these options would offer a financial advantage over the traditional LLC tax treatment. Given the recent tax law changes and the 20 percent business deduction that some businesses qualify for, you might discover that pass-through tax treatment will offer the most benefit.
As I mentioned earlier, though, every situation is unique, so it’s important to explore all available options to assess how they will affect the client.
LLC Tax Election – C Corporation Tax Treatment
An LLC may elect (on IRS Form 8832) to be treated as a corporation for tax purposes and pay taxes on company profits at the corporate tax rate. Unlike with pass-through tax treatment, not all LLC profits are subject to self-employment taxes. Profits distributed to members as dividends get taxed to the individual owners as ordinary income.
The double taxation of distributions (taxed initially at the corporate tax rate and then again at the individual level) may make corporate tax treatment more costly. However, the math might work in a client’s favor now that the federal corporate tax rate has been lowered to 21 percent. The difference between the state’s corporate and individual tax rates might have a significant impact on the end result.
Something for clients to keep in mind is that when an LLC is taxed as a corporation, it must set up and handle payroll taxes on wages and salaries paid to the LLC members that work in the business.
LLC Tax Election – S Corporation Tax Treatment
Another option for LLCs is S Corporation tax treatment (via filing IRS Form 2553 after making its entity classification election on IRS Form 8832). Unlike a C Corp, an S Corp does not pay corporate taxes on its profits. Instead, it receives pass-through taxation, whereby LLC members (according to their profit allocation percentages) pay tax on business profits on their individual tax returns. What’s attractive about S Corp treatment for a lot of LLCs is that only members’ wages and salaries are subject to self-employment taxes. LLCs taxed as S Corps must set up payroll, ensure all members working in the company are paid a fair market wage or salary, and make sure all tax and other withholdings are processed accurately.
Knowledge is Power: Empower Your Clients
As you have conversations with your clients about how to run their businesses more profitably, remind them that choosing the right entity type can have an impact in a variety of ways from the degree of personal liability protection they offer to the income tax burden they will bear. I hope that what I’ve shared will help you keep the LLC structure’s tax implications top of mind, and I encourage you to reach out to each other as sounding boards and sources of support when answering clients’ questions.
Nellie Akalp is a passionate entrepreneur, small business expert and mother of four. She is the CEO of CorpNet.com, a trusted resource for Business Incorporation, LLC Filings, and Corporate Compliance Services in all 50 states. Nellie and her team recently launched a partner program for accountants, bookkeepers, CPAs, and other professionals to help them streamline the business incorporation and compliance process for their clients. More info at:CorpNet.com/partners