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How Are LLCs Taxed?

By IncNow | Published August 4, 2016

LLC tax election choicesFour out of five businesses that incorporate with IncNow choose the Delaware LLC over the corporation. Two reasons for that are the flexibility and simplicity of Delaware LLCs. By default, an LLC has a federal tax status of a partnership for a multi-member LLC or the tax status of a sole proprietorship for a single member LLC. These are considered “pass-through” entities for tax purposes, where all of the profits and losses pass-through the business to its members (owners) or sole member. These owners then pay taxes on the profits, or deduct the losses, on their individual 1040 personal income tax returns. Therefore, the business entity does not pay taxes directly. Instead a multi-member LLC only files an informational partnership tax return referred to as an IRS Form 1065. Then its members receive a K-1 for their share of the profits or loses, which by agreement can be distributed disproportionate to ownership percentage.  A single member LLC does not need any additional return other than the owner’s IRS Form 1040. For the single member LLC, the income and expenses are reported on the Schedule-C of the IRS Form 1040 tax return. This results in all profits being automatically self-employment income. This tax can be burdensome and result in a higher effective tax rate because all the profits are treated as “earned income” subject to self-employment taxes.

To reduce the self-employment taxes, the owners are allowed to make the two corporate tax elections under IRS “check the box” rules on behalf of the LLC, should the owners not want the LLC to be taxed as a sole proprietorship or partnership. The two corporate tax elections are known as a “C” (on IRS form 8832) or “S” election (on IRS form 2553). Causing an LLC to make one of the two tax elections means the LLC will need to file an 1120 or 1120-S US Corporation Income Tax Return. While LLCs taxed as C-corporations can result in “double taxation” that does not necessarily result in a higher effective tax rate. Counterintuitively, sometimes the double taxation of a C-corporation can be managed and structured to result in the lowest available tax rate for your LLC. This often requires making someone else a 6% non-employee owner to avoid the personal service corporation rule. This rule is something unfamiliar to many accountants and lawyers, but it works and lets the first $50,000 of income be taxed at 15% rate which can then be borrowed from the company as a loan, not subject to tax. Utilizing this technique should be done carefully and in consultation with a tax advisor. The main difference between the “S” and “C” corporate tax elections is that the “S” election allows the profits and losses to pass through the LLC to avoid double taxation on corporate income, thereby only taxing the individuals on the personal amount distributed to them on a personal income tax level. After paying a reasonable salary, the remaining “S” corporation dividends are treated as passive income, not subject to self-employment taxes. This results in savings on the Medicare and social security tax allocated on up to half of a company’s income. Allocating more than 50% of an “S” corporation income to the “S” dividend, and not salary, can be considered abusive and is not recommended.

C-corps have a negative reputation because they are thought of as resulting in higher taxes. Surprisingly, a C-corporation election can lower your taxes if done properly on a modest consulting business or small operating company. The tax rate paid by the corporation can be low and the dividend then paid to stockholders is then taxed again as a dividend. The C-corp has the added benefit of being able to pick a fiscal year to allow for income shifting. The C-corp also allows profits and losses to be carried forward for a business with oscillating profits and losses or even a series of losing years before it becomes profitable. For example, a business with heavy equipment purchases should consider a C-corp from the beginning.

The business that should never make an S-corp election or be a C-corp is a real estate investment business. Land should always be held through an LLC taxed as a partnership or sole proprietorship. That allows for profits, from sales in the future to be taxed as long term capital gains, rather than ordinary income, which is a lower effective tax rate.

Therefore you should consult with a tax advisor within 75 days after the formation of your LLC or corporation to decide if you want the default tax status or make a corporate tax election to reduce your effective tax rate. You do not need to form a corporation to make a corporate tax election. Under the IRS “check the box” rules LLCs are also eligible for “S” and “C” tax treatment, but more importantly they default to partnership/sole proprietorship status and have many non-tax benefits superior to corporations.

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When deciding where to form your company, consider that Delaware has advantages over your home state that may benefit you. Go